Cross-collateralisation. It’s a term that you may have heard bandied about when people are talking about home loans. But what is it exactly?
It's when more than one property is used as security for a loan or multiple loans.
For example, a borrower may have a home worth $700,000 with a home loan of $100,000 remaining. Should they wish to purchase an investment property worth $500,000, they can avoid the need to provide a deposit by cross-collateralising both properties. This would involve a new loan of about $550,000 (note – this would include stamp duty, legal fees, & other costs that apply), and would result in total lending of $650,000 being secured by properties worth a combined total of $1,200,000 – an LVR (loan-to-value ratio) of 54.2%.
Over the years we’ve been approached by people who went ahead with cross-collateralisation for a purchase because “the bank told us that we didn’t need to pay any deposit or stamp duty and legals from our funds if we cross-collateralised the properties.”
Due to the lower LVRs involved with cross-collateralisation, some lenders may be willing to offer more competitive interest rates. Lenders also tend to be more comfortable with the additional security that is provided as a result of cross-collateralisation.
→ So what's the problem with that?
Generally speaking, cross-collateralisation works quite well – until you don’t need it, or want it, any more.
The primary issue with cross-collateralisation is that it reduces your flexibility to manage, refinance, and sell multiple properties independently of each other. Instead, it gives substantially more control to the lender. This is because the total equity in your properties is under the control of one lender under one mortgage.
Take, for instance, if you wish to sell an investment property that is cross-collateralised with your home. Following the sale, your lender no longer has that property as security – the sale of the property and discharge of a loan would alter your LVR (loan-to-value ratio). As a result, your lender may require the full sale proceeds to be used towards reducing the remaining loan, rather than being transferred as cash into your bank account. Worse still, the lender may not be satisfied with the entire sale proceeds and could require you to sell your home as well.
This is particularly troublesome if you are unable to make your loan repayments and the lender decides to foreclose. Where multiple properties are held as security for a mortgage, the lender can choose which property needs to be sold – or even take possession of them all. This is not the case where properties are mortgaged separately, particularly if they are held with different lenders and you only fall behind on one loan.
Recently, we were contacted by someone who had lost his job and wanted to take a year off before getting back into the workforce. He sold one of his investment properties to provide him with some cash flow. Because the property was cross collateralised with his home, he had to ask the bank’s permission to sell the property. Upon finding out that he had no job, the bank kept 100% of the proceeds of the sale to reduce his home loan! Needless to say, he had to cancel his sabbatical and find a new job.
Should you wish to refinance, for whatever reason, cross-collateralisation presents an issue if you don’t want your properties financed in this way going forwards. Instead of having one property valued and subsequently refinanced, you would need to go down this route for all properties that were cross-collateralised. This results in extra time spent and costs incurred on your part. Furthermore, an adverse valuation of just one property can potentially complicate the entire refinance, or even prevent it altogether.
If, in the future, you are aiming to finance another property and grow your portfolio, your options are restricted if your properties are cross-collateralised. Changes to serviceability assessment, appetite for certain types of loans (e.g. interest-only investment loans), or a lower-than-expected valuation of one of your properties can leave you with no options, or a process of refinancing and releasing equity that is longer and more difficult than is ideal.
In short, cross-collateralisation tends to result in ‘sticky customers’. The reason that lenders are more comfortable with cross-collateralisation is because it:
Lenders like it because it gives them control – not because it is innately beneficial for the customer.
Finally, it should be noted that the benefits of cross-collateralisation (lower LVRs, and avoiding the need to dip into your own savings) can be achieved without cross-collateralising the properties. Indeed, you don’t even need to have the properties mortgaged to the same lender! Moreover, there are loan structures that include buffers and provide flexibility to investors which are usually not offered with cross-collateralisation.
A good mortgage broker can provide valuable assistance in structuring your finances in a way that avoids cross-collateralisation or, if you are already in this situation, can assist you in unravelling it.