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One type of loan that isn’t often discussed is cross-collateralized, also known as cross-collateral loans, which is a type of secured loan. If someone is looking to take out multiple loans through the same financial institution, it’s important that they understand what cross-collateralization is and when it can happen.
So what is a cross-collateralized loan? Keep reading to find out.
Key Points
• Cross-collateralization involves using the collateral on one loan to secure another one with the same lender.
• One common example is taking out a second mortgage, though cross-collateral loans don’t have to use the same asset for a similar loan type.
• Cross-collateralized loans are more common at credit unions and auto lenders than they are at banks.
• Lenders are legally obligated to disclose cross-collateralization, whether that be verbally or in the written loan agreement.
• Cross-collateralization is typically easier to qualify for and may have a lower cost, but these loans are tied to a single lender, and borrowers run a greater risk of losing their collateral.
What Is Cross-Collateralization?
Cross-collateralization is when a lender uses the collateral you put up for one loan, such as a car, to secure another loan you take out with that same lender. Collateral is an asset that acts as a loan guarantee. If the borrower fails to make their loan payments, the lender has the option to seize the collateral or to force the sale of the collateral to recoup its losses.
How Does Cross-Collateralization Work?
The way that cross-collateralization works is that the same form of collateral is used to back more than one loan. The collateral used needs to guarantee the loan value. For example, if someone takes out an auto loan, the car (which equates to the value of the loan) is used as collateral. Once that loan is partially paid off, the lender may be willing to use the car as collateral for a second loan. Generally, for cross-collateralization to work, that car also needs to be worth the same as or more than the value of both loans.
A common example of cross-collateralization is a second mortgage. If someone takes out a second mortgage on their home, the home is going to be used as collateral for both the primary mortgage used to purchase the home and the new second mortgage.
While cross-collateralization can involve using the same asset for similar loan types, it doesn’t have to happen this way. For example, a lender can use a borrower’s car as collateral for a new loan that isn’t an auto loan (such as a personal loan) even though the car is already being used as collateral for the auto loan.
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When Is Cross-Collateralization Used?
It’s more common to come across cross-collateralization in practice at credit unions and auto lenders. Unlike banks, credit unions are owned by their members. To help protect this group against various losses, credit unions often use cross-collateralization to gain some extra security. Credit unions tend to have more favorable loan terms than larger financial institutions and banks, and members may secure those better terms by agreeing to cross-collateralization.
An example of this would be if a credit union member wants to finance their car through their credit union. Fast forward six months, and they want to take out an unsecured loan with a low interest rate. The reason the credit union can offer an unsecured loan to the member at such a great rate is that they are actually securing the loan with the existing collateral from the member’s car loan.
The lender is legally obligated to disclose cross-collateralization, and the borrower must consent. It’s important to ask about cross-collateralization practices when taking out a new loan, however. Rather than verbally explaining the cross-collateralization to you, a lender could simply include a clause in the loan agreement allowing it to cross-collateralize any collateral you used on any loan with that lender. The wording in such a clause can vary by lender.
Once a form of collateral is used to secure multiple loans, the borrower may not be able to sell that collateral. If the borrower isn’t aware that the collateral they put up for their original loan is also being used to secure the second loan, this could come as an unpleasant surprise. For example, a borrower might try to sell their car after paying off their car loan, believing they own it free and clear, only to discover that they can’t sell it until they pay off a second “unsecured” loan they have with that lender.
How Can You Get Out of Cross-Collateral Loans?
Getting out of a cross-collateralized loan without paying it off in full can be difficult. Plus, it can be challenging and expensive to move a cross-collateral loan to another lender, which can leave a borrower stuck with whatever rates and terms were offered to them when they took out the loan. That’s why it’s a good idea to read the fine print of any loan agreements before signing and confirming whether a bank or credit union plans to start a cross-collateral loan.
Pros and Cons of Cross-Collateral Loan
| Pros | Cons |
|---|---|
| Easier qualification | Higher collateral risk |
| Lower potential cost | Dependence on one lender |
| Use of existing assets as collateral | Less unfavorable terms |
There are some major advantages and disadvantages associated with cross-collateral loans that are worth taking into consideration before signing any loan documents.
Benefits
Here’s a look at some of the benefits of a cross-collateral loan.
• Easier qualification: Because cross-collateral loans are secured, they can be easier to qualify for than unsecured loans, for which the lender takes on more risk. Applicants with low credit scores may find it easier to qualify for this type of loan than some others.
• Lower potential cost: Cross-collateral loans tend to be less expensive than unsecured loans. This type of loan tends to come with lower interest rates, which could lead to savings over the life of the loan. (However, they may come with longer repayment terms, which could increase the total interest cost.)
• Leverage of existing assets: Cross-collateral loans use an asset that is already trapped in an existing loan and allow the borrower to get more value out of it by using it to secure more loans.
Drawbacks
There are also some serious downsides associated with cross-collateral loans that are worth thinking carefully about.
• Risk of losing collateral: If the borrower isn’t able to repay their debts, the lender can seize the asset acting as collateral.
• Reliance on one lender: With a cross-collateral loan, more than one loan is secured by the same asset, all through one lender. This can make it hard and expensive to ever switch to a lender offering more favorable terms.
• Potentially less favorable terms: Cross-collateral loans can have stricter terms to meet in order to protect the lenders on subsequent loans.
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Cross-Collateralization and Bankruptcy
Cross-collateralization can become particularly complex during bankruptcy. For example, a borrower of a cross-collateral loan (using their car as collateral) who files for Chapter 7 bankruptcy will be required to either reaffirm the debt or surrender their car.
If they choose to reaffirm the debt and that loan is with a financial institution that has secured other sources of debt to the car, then they will need to pay off all of those debts in order to keep their vehicle. Don’t forget that the borrower may not even be aware that some of their loans were cross-collateralized.
How cross-collateralization affects bankruptcy depends on the type of bankruptcy filed. Anyone dealing with cross-collateralization complications during bankruptcy may find that consulting a bankruptcy attorney will help them determine what their next steps should be.
Recommended: Getting Approved for a Personal Loan After Bankruptcy
The Takeaway
Cross-collateralization can be tricky because it ties multiple debts to one asset, meaning you risk losing your collateral if you can’t make payments. While these loans are sometimes easier to qualify for or offer lower costs, they also limit your flexibility and make it hard to switch lenders later. Before signing any loan agreement, always read the fine print to see if cross-collateralization applies.
If you’re looking for an alternative to a cross-collateralized loan with your existing bank or credit union, you may want to investigate taking out an unsecured personal loan through a different financial institution. Personal loans can be used to finance a variety of expenses, including large purchases, home repairs/renovations, medical expenses, car repairs, weddings, vacations, and more.
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FAQ
Is cross-collateralization legal?
Yes, cross-collateralization is legal. Many banks and credit unions practice cross-collateralization.
Who can and can’t cross-collateralize?
Borrowers who already have a secured loan at a financial institution may qualify for cross-collateralization. Lenders don’t always inform borrowers verbally that they are participating in cross-collateralization, so it’s worth confirming whether or not this is happening before taking on a second loan through the same lender.
Can you get out of cross-collateralization?
A major downside of cross-collateralized loans is that once a borrower has multiple cross-collateral loans through the same lender, it can be difficult to move them to another lender. Paying off the loan is usually the preferred option for getting out of cross-collateralization.
About the author
Jacqueline DeMarco
Jacqueline DeMarco is a freelance writer who specializes in financial topics. Her first job out of college was in the financial industry, and it was there she gained a passion for helping others understand tricky financial topics. Read full bio.
Photo credit: iStock/mapodile
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