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Home Business Loans Cross-Collateralization: What is it and How Does it Work?
As a small business owner, you’re probably familiar with at least a few of the many loan products available. Many lenders require you to offer an asset to secure a debt. As time goes by, you might find yourself securing multiple loans with the same asset—a process called cross-collateralization.
Cross collateralization is fairly common—“second mortgages” are a popular form of cross-collateralization, for example. There can be many benefits to taking advantage of cross-collateralization, but this process also increases the risk of losing assets, so it’s important to understand how cross-collateralization works before making any formal arrangement.
There are 2 main types of loans: secured loans and unsecured loans. These loans differ in regard to collateral requirements. Collateral is an asset that a borrower offers up as a way to guarantee the amount of a loan. Common forms of collateral include cash deposits, real estate, or vehicles.
Secured loans require collateral, while unsecured loans do not. If you default on secured loans, the lender can seize the collateral as repayment for the loan amount. Lenders of unsecured loans, like credit cards, have no such recourse, but this usually causes the repayment terms of unsecured loans to be less favorable for the borrower.
In many cases, a lender uses an asset to secure the loan for that very asset. This is common with home mortgages, car loans, and equipment financing. If you have a mortgage, your house is the collateral—so if you default on your mortgage, the lender then can collect the collateral and repossess your house.
Cross collateralization refers to a situation where multiple loans are secured with the same asset.
In a second mortgage situation, your home serves as collateral for a mortgage. As you pay down your mortgage, you own more of your home. You can then use your home as collateral for a second loan, i.e., a second mortgage.
Cross collateralization also occurs if different types of financing are secured with the same asset. If you’re paying off a car loan, the car becomes collateral for this loan. If you use the car as collateral for another type of financing, like a credit card, this is cross-collateralization.
“Cross-collateral refers to a method that lenders use to utilize the collateral of a loan such as a car to secure a second loan that an individual may have with the lender,” explains Jason Gordon at The Business Professor. “When an asset is cross-collateralized, it brings up issues as to which secured party has priority to the asset in the event of default.”
Less commonly, cross-collateralization also refers to a situation when a lender requires multiple forms of collateral for a single loan.
Cross collateralization is legal and fairly common, but a lender is required to inform you that cross-collateralization is occurring.
If you take out multiple secured loans from the same lender, like a bank, it might use the same collateral, making your assets cross-collateralized. You must legally consent to this, but do your due diligence in reading over any loan agreement. Be especially aware of “dragnet clauses” where a lender can pursue your asset if you used it for collateral for any loan with the lender.
“Lenders cannot use your business’s property as collateral without your consent,” writes Shawn Grimsley in the Houston Chronicle. “Lenders obtain your consent to cross-collateralization through a dragnet clause, which may allow the lender to use the collateral for any loans or other obligations your business may owe the lender.”
If you can make your loan repayments on time, you’ll probably have no issues with cross-collateralization. Trouble arises if you default, however. If an asset is cross-collateralized and you default on one of your loans, you will default on all of your loans, because the asset can no longer secure any of them.
Banks cross-collateralize often, but cross collateralization is even more common with credit unions. Cross-collateralization is especially conventional when you seek multiple loans from a single lender. With every loan you take out, read over the agreement and make sure you consent to how a loan is secured.
The best way to untangle yourself from a bad cross-collateralization situation is to contact the lender and attempt to renegotiate your loan. You might, for example, be able to secure the remaining debt with other collateral, although the repayment terms might be worse.
Bad cross-collateralization situations usually end with the loss of the asset, even if you declare bankruptcy. Unfortunately, besides repayment, the only way to get out of cross-collateralization is by letting your lenders repossess the collateral.
Barry Eitel has written about business and technology for eight years, including working as a staff writer for Intuit's Small Business Center and as the Business Editor for the Piedmont Post, a weekly newspaper covering the city of Piedmont, California.
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