Like many things in finance, cross-collateralisation is a lot more simple than it sounds. In saying that, without a solid understanding of cross-collateralisation, it can be easy for investors to get themselves into trouble.
Read on to learn about the potential dangers, benefits and alternatives to cross-collateral loans.
What is cross-collateralisation?
Cross-collateralisation, or cross-securitisation, is the practice of using two or more properties as security on one or more home loan, as opposed to the traditional custom of using one property. It’s an often maligned approach as it opens up investors to the danger of losing control of their portfolio and as a result, it’s typically only recommended as a portfolio-building tool for those not planning to sell any property for at least a decade.
Property investment generally begins with the home you live in, which you have a mortgage on and are steadily building equity in over the years as you make your loan repayments. Once your loan to value ratio (LVR) is substantially below 80%, lenders may allow you to access some of your equity to use as a deposit for a loan on another property, which can be a lot quicker and easier than saving up a deposit for another property in a bank account.
Here’s where cross-collateralisation could come in - you may be able to use you the home you live in, with the equity you’ve built in it, as security for buying another property. It’s important to note that you can only cross-collateralise with one lender though, which is why it's considered so risky.
Here’s a simplified example: Your home is worth $800,000 and you’ve paid off your mortgage, hence you have $800,000 in equity. You decide you want to buy a $400,000 investment property but you don’t have the cash for a 20% deposit. So you go to a lender and ask to use your home as the security for a $400,00 loan to buy the $400,000 investment property. If approved, this means that this one loan is secured by two properties worth a combined $1.2 million, putting the lender in a very safe position with an LVR of 33.33%.
What are the benefits of cross-collateralisation?
For many property investors, cross-collateralisation is considered taboo. But there can be some benefits to it:
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Easy equity: Unlocking the equity in the home you live in lets you skip the painstaking process of saving up for another deposit for a loan and affords you the convenience of quickly seizing an investment opportunity. Cross-collateralisation can make this easier to do, as well as accessing equity for things like renovations.
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Convenience: As you can only cross-collateralise with one lender, all of your loans are in one place with the same financial institution. This can make your portfolio much easier to manage, rather than having several loans across different lenders. Having one lender may also save on some fees.
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Potentially lower interest rates: Cross-collateralisation can give a lender more power and control over a borrower’s property portfolio while lowering its risk exposure. As such, lenders may be more inclined to offer you a lower interest rate on a cross-collateralised loan, which could save you thousands over the life of the loan.
What are the negatives of cross-collateralisation?
Cross-collateralisation can have a massive impact on your investments and the negatives are often thought to outweigh the benefits. Take a look for yourself:
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Less control: While having all of your loans with one lender may make things more manageable, it also hands much of the control of your portfolio over to that lender. If you decide to sell one of your properties, the bank can dictate the terms of the sale and where the funds from the purchase end up. They might decide that all of the funds are put towards paying down a loan and you won’t see any of the cash.
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Higher risk of losing your home: Including your home in your cross-collateralised property portfolio could put it at greater risk. Since it’s being used as security for one or two other properties, the lender could have just as much right to force the sale of your owner-occupied house as the investment properties in the portfolio.
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High valuation costs: Because of the way properties are linked under cross-collateralisation, each property needs to be professionally-valued every time there’s a substantial change to the portfolio or the loan, including every time a property is bought or sold. This can be incredibly time consuming and costly, as having a property professionally valued can cost several hundred dollars each time.
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Restrictions: Another drawback of having all of your loans with one lender is the restrictions that may apply to you. Lenders could restrict the types of loans you can apply for, such as limiting you to principal and interest loans - a problem for investors who usually prefer interest-only loans.
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Difficulty refinancing: It can be more difficult to refinance in any way when in a cross-collateralised structure. With all your property’s intertwined it can be a difficult task trying to untangle the complex web. On top of this, the costs of refinancing are likely to be higher.
Factors to consider prior to cross-collateralising
As well as weighing up the pros and cons there are a number of factors you should consider prior to deciding to cross-collateralise:
Lenders mortgage insurance
Lenders mortgage insurance (LMI) is an insurance policy which covers the mortgage lender against the losses they may incur in the event the borrower can no longer make their loan repayments.
Typically LMI is paid when the property has an LVR greater than 80% and less than 95% (an LMI greater than 95% means your loan application will more than likely be rejected).
For example, buying an $800,000 property with a $100,000 deposit would see you pay almost $13,000 in LMI, according to Genworth.
If your portfolio was to fall into an unfavourable LVR, then you would have to pay LMI on every property in the portfolio, potentially costing you tens of thousands of dollars.
Stamp duty
Should your cross-collateralised property span different states and territories, you’ll have to consider the different regulations that come concerning stamp duty between each area. You could end up paying stamp duty on both the property you’re buying and the property (or properties) you’re using as security. This is another cost which could end up costing tens of thousands.
Cash-flow
If you’re relying on tenants residing in your investment properties as a main source of income then this could become a complication when cross-collateralising. Should tenants move out of a property you own and you fail to quickly find new tenants you may struggle to meet loan repayments. As a result of the bank controlling your portfolio, they could force you to sell your house to cover the cost of repayments.
Stand-alone security vs cross-collateralisation
Stand-alone security refers to the standard process of using one property as the security for one home loan, typically the home you’re purchasing. It’s important to understand when talking about cross-collateralisation as its the more traditional process of purchasing a home.
You can still use equity to purchase an investment property via the stand-alone security method. For example, if you had an $800,000 with a $400,000 home loan on it you would have $400,000 equity in the home. If you then wanted to buy a $150,000 investment property, you could refinance the loan on the home to release $30,000 of equity to use as a 20% deposit for a separate loan to purchase the investment property. Two separate loans for two separate properties.
Because of the aforementioned complications associated with cross-collateralisation, many property investors prefer to take the stand-alone security option when buying an investment home. It can give you greater control over your portfolio and where funds are directed following the sale of a property. Furthermore, it’s not necessary to get constant valuations and one property’s value crashing generally won’t affect every other property you own.
How to avoid cross-collateralisation
Many lenders love cross-collateralisation for the extra control and risk mitigation it provides - so much so that some borrowers have in the past been cajoled into signing up for such arrangements without being explicitly aware of it.
Make sure to check through your home loan contract prior to signing to see what your securities are. It can also help to have a conveyancer do the same. If you discover that lender is cross-collateralising your properties, you could request to have this changed.
The easiest way to avoid cross-collateralisation is to have separate loans for each property in your portfolio, preferably from a variety of lenders.
Savings.com.au’s two cents
Cross-collateralisation is an oft-maligned investment strategy for good reason.
It takes a lot of hard work to build up an investment portfolio, so you can understand why investors would be reluctant to hand a lot of control of that over to a lender. The costs of managing your portfolio can also be a lot higher.
So be sure to consider whether you’d be better off buying an investment property through the stand-alone security method before you sign up for cross-collateralisation.
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