Cross Collateralization

Cross collateralization is the act of a lender securing more than one property in order to place a new loan. So what exactly does that mean?

Cross Collateralization in Practice

When mortgage lenders make loans they evaluate both the borrower as well as the property being financed. The borrower should have shown the willingness and ability to repay monthly credit obligations on time, show sufficient income in which to pay these obligations as well as provide evidence there are enough funds to close on the transaction. Funds include money needed for a down payment, closing costs and cash reserve requirements. The property must be in good shape, marketable and similar to other properties in the area. They do so in the event of a default and the lender must foreclose. When they do, they will sell the property, hoping to recover enough at an auction or a direct sale to cover the outstanding loan balance plus recover the necessary legal fees accrued during the foreclosure and selling process.

The property is the collateral in which the lender has a legal interest. If the owners sell the property, the outstanding mortgage is the first to get paid. If the mortgage amount is greater than the value of the property, the owner must come to the settlement table with cash to settle the outstanding balance or the lender agrees to accept less as payment in full. When borrowers come to the settlement table with a down payment, the equity in the property is the borrower’s initial good faith.

How it Works

Let’s say that a buyer wants to purchase an investment property for $200,000. The buyer currently owns several properties and one of them is free and clear, having paid the mortgage off completely a few years ago and is valued today at $150,000. The buyer wants to leverage the new home as much as possible with a low down payment. A lender offers to issue a mortgage on the new property in the amount of $190,000 if the buyer agrees to allow the lender to file a lien against the property that is free and clear in addition to the new first lien on the new home. The additional equity in the mortgage-free home gives the lender more security making the new loan while allowing the buyer to buy the new property with as little down as possible.

In this example, should the borrower ever go into default on the new mortgage, the lender can force the sale on both properties in order to settle the outstanding balance, closing costs and legal fees. Cross collateralization is not a common method of financing residential real estate but the practice does exist.

Final Thoughts

Cross collateralization is more common when financing commercial properties, however. Private lenders are more active in cross collateralization. Conventional loans underwritten to guidelines established by Fannie Mae and Freddie Mac do not allow for cross collateralization nor do government-backed loans such as FHA, VA and USDA programs.