Cross collateralization borrowing is when the borrower looking to buy Asset “A” using Asset “A” as well separate Asset “B” as security on the loan. The key is that Asset “B” is already used as collateral on a separate loan but will be used as secondary security on the Asset “A” loan.
Cross collateralized borrowing can be attractive for lenders (either Big 4 Bank or non bank lenders like AMP) is that they will have additional security against what they lend over what they would have without it. This potential means interest cost on these borrowings can be cheaper.
However we should note that while the low cost of borrowing is a clear benefit of cross collateralization, there are also risks associate with this borrowing strategy.
The advantages and disadvantages entirely depends on the individual circumstances but here are some key highlights:
Potential on Ongoing Equity withdraws
As condition of withdrawing equity the bank could require an updated valuation of the asset. In this instance where all assets and lending are grouped together, then it could be a revaluation of the whole portfolio.
In the case that investor looking to take equity out of their investment which they own their home in Sydney which is benefiting from a strong Sydney property boom as well as a house in Perth where the Perth property market is in the slump.
Overall gain is cancelled out by the loss elsewhere in the portfolio. The outcome means they will not be allowed to take out more equity.
If the assets were held separately, then investors could focus on withdrawing equity from the strongly performing asset that is expected to have revaluation gains.
Concentrated Borrowing Exposure
Usually the first requirement for cross collateralize loans is that the same bank must provide all the lending. The investors will be exposed to the banks lending and interest rate policy across their whole portfolio. This means that when the banks raised interest rates on investment post APRA directive.
The investors monthly interest cost rose across the whole portfolio leaving limited response time to adjust.
In the case if the borrowing facilities were separate across multiple lenders. The investor would have to only refinance a portion of the portfolio that saw the increase in interest costs.
By retaining all borrowing exposure with a single bank, the borrower is trapped unless they meet credit and lending criteria of another lender for their whole portfolio.
Additionally, if the LVR in the portfolio is on the high end then lender mortgage insurance (LMI) would be required. LMI would be lower for a partial refinancing than portfolio refinancing situations.
Restriction on Proceeds for Sale
If one of the asset is sold is a cross collateralize relationship. The bank could dictate first priority of the proceeds to repaying current total amounted borrowed.
This means the equity portion of the proceeds can be nominated by the bank to repay them first before any withdrawals thereby reducing total capacity to reinvest the equity to make up the lost income from the asset just sold.
For example if assets are held in separate bank loans. If investors sells one asset they can repay the bank that lend against the asset only and use the equity proceeds for another opportunity.
If assets are cross collateralized, then the banks could require the borrower to use all of the proceeds to reduce the total loan outstanding. If the intention is always to reduce debt then both cases will result in the same outcome.
However if the investors are looking for flexibility in withdrawing equity then cross collateralization complicates the process.
To recap all the points above. The key impact from cross collateralization is increasing the complexity and liming flexibility at a potential lower interest rate. It is up to each investor to judge if the trade off is worth in the medium and long run.
Another way looking at this is that borrowers need to understand that only because the loans are under separate accounts within the same bank such as credit card and mortgages means that all accounts are linked together through the “all money” clause.
Any asset can be called to repay anytime which in means that they can even force sale your home to repay a credit card debt or in our example force sale of first asset to repay total debt outstanding. While this is the extreme and unlikely unless the borrower is grossly negligent, nonetheless it is an interesting fact to know.
If loans are separated across multiple banks then one property could be sold and pay out the loan without involving the other properties.