Cross-collateralisation occurs when more than one asset is used to secure a loan or multiple loans.
For example, a person owns Property A and wants to purchase Property B without using any of their own funds. The bank can use both properties as collateral for the new loan.
Many investors have cross-collateralised loans without knowing it.
It suits banks to cross-collateralise loans and they can be very persuasive in encouraging borrowers to do it.
Borrowers would be wise to be aware that banks are motivated by profit share and control over a client’s entire portfolio.
Cross-collateralisation has the potential to negatively impact future growth opportunities.
Whether you are building a portfolio of multiple assets for a property investment portfolio or a business owner with multiple assets, cross-collateralisation is to be avoided.
1. LOSS OF FLEXIBILITY
If a portfolio of assets is cross-collateralised it can limit severely the way in which proceeds may be used in the event of a sale of an asset.
For example, if a property is sold, the bank might require that the sale proceeds are used to reduce other loans in that portfolio, to keep the Loan to Valuation Ratio (LVR) within a certain level. In that case, the loan proceeds would not be able to be used at the investor’s discretion.
2. INCREASED COMPLEXITY
It is often the case that every asset in a cross-collateralised portfolio needs to be re-valued whenever one asset is released. There may be significant costs associated with valuing each asset, especially if the portfolio is not within a loan package product. The valuations are undertaken in order for the bank to determine its exposure with the remaining assets. In addition, there is documentation to be executed every time a portfolio is changed. This paperwork is known as a Variation of Security.
3. LIMITED PRODUCT CHOICE
In general, most property investors favour Interest Only loans. As an investor’s exposure increases with any one lender, that lender can restrict future loans to only Principal and Interest. Regardless of one’s asset position, many banks will want to control the type of loan that they will make available to an investor when his or her aggregate debt with them is high. A better strategy is to use multiple lenders and therefore gain access to the most suitable loan products.
4. CHANGING LENDERS CAN BE DIFFICULT AND COSTLY
When a loan(s) is secured by multiple assets, the establishment fees are usually higher as they include charges for ‘additional’ security. This cost can be compounded when an investor wishes to move those cross-collateralised assets from one lender to another. Exit fees can be significant, especially if any of the loans are fixed. In addition, new valuations may be required (as explained above) where the borrower wishes to release assets.
5. EQUITY ACCESS
As the value of one or more assets increases, it is quite common to look to access the extra equity in order to acquire additional assets. This is particularly common amongst property investors. If all assets are cross-collateralised the borrower is completely at the mercy of one bank supporting their application to access equity and keep building the portfolio. That’s an awful lot of power that rests in the hands of one organisation. It would be foolhardy to assume that banks always say ‘yes’ to loan applications. There is a wide variety of reasons as to why a bank may decline a loan application, or approve it but on terms that are not ideal. If this eventuated, the borrower’s life plans get placed on hold.
If the loans were not cross-collateralised, an application to increase the loan or credit limit against individual assets that have increased in value would be a relatively simple process. The borrower is then able to continue to move forward with their growth strategy.
HOW CAN CROSS-COLLATERALISATION BE AVOIDED?
Avoiding cross-collateralisation is an important ‘risk management strategy’ which all borrowers are encouraged to adopt. Whenever possible, attempt to acquire stand-alone loans and securities. Take out separate loans for each new asset with the deposit and costs coming from an established line of credit or offset account secured by alternative assets.
About Propertyology Head of Research and REIA Hall of Famer, Simon Pressley
Simon Pressley is a 3-time Australian Buyer’s Agent of the Year, an REIA Hall of Fame Inductee, a tertiary-qualified Property Investment Advisor, and a graduate of Australian Institute of Company Directors. His reputation as a thought-leading property market analyst is unparalleled, including correctly forecasting Hobart’s boom, Sydney-Melbourne’s last downturn, numerous regional star performers, and Australia coming out of COVID with the biggest boom in more than 15-years.