What is Cross Collateralisation, and How Does it Work?
Setting up your lending correctly from the very beginning when starting or growing your property portfolio is an important part of your strategy. Some common mistakes investors may make are:
Paying principal and interest in investment properties rather than paying the extra funds onto their owner-occupied property.
Not separating funds that are for investment from owner occupied debt. i.e. using redraw or savings to fund a deposit of an investment property.
Putting excess funds into redraw rather than offset of a property that is or will be an investment property.
And the most common and easily avoidable
Cross collateralising your home with an investment property or two investment properties.
This is the situation that we will be exploring in more detail in this blog.
Most clients that come to us to rectify the issue of being cross collateralised did not know that their securities were crossed until something went wrong, so I urge anyone with an investment property or more than one property to firstly, check if your properties are crossed, and secondly, do you understand why?
Cross collateralisation is when a bank holds more than one property for one or more loans. They hold both properties and lend for both purposes. The lending is split for accounting purposes but the bank holds two deeds, and the loans and the securities are joined. This gives the bank more power and opens the borrower up to future complications.
Generally, it starts with a home that has equity in it. The bank simply takes that property and the next purchase, holds them both together and lends 100% plus costs for the investment purchase. It gets sold to the client as the way to “avoid lenders mortgage insurance”, however there is a less risky way to do this.
The way to protect and separate your assets while still using the equity you have in property one is by borrowing for the deposit and costs against property one, then using that to borrow for property two. Some of the benefits are:
The bank only has one property for that loan (or loans) so there is only one property securing it.
You can opt to have it set up with one or multiple lenders.
A poor valuation only affects one loan, not multiple loans.
When you opt to sell a property the bank only controls the lending against that property.
An example of where a client has been caught out with cross collateralised loans:
Client had one owner occupied (OO) home with a small $100K loan on it, and two investment properties. The OO home is worth $800K., and the investment properties are about $750K each (bought for $525K each) The bank held all three properties to secure the home loan of $100K and the two investment loans of approx. $550K each. The client’s wife was not working when he sold Investment Property 1. The goal was to sell property for $750K, pay out the $550K loan and use the rest of the funds to place into Super. As the loans were all crossed and the bank held all securities, they enforced that the other investment loan be paid down with the remaining funds as the client did not service the remaining debt at that time. If he had uncrossed these securities initially, or even a year before when the equity allowed and his wife was still working, he would have control of the funds, not the bank.
A more simple issue may be that the equity in one property increases and you wish to take that equity out, but the valuation of the second property comes in lower and as they are crossed, it does not allow you to use that equity.
When I worked for the bank directly we were always taught to cross the loans. I truly believed at the time it was in the client’s best interest but time and experience has taught me it was more in the bank’s interest, as it is very hard to change lenders when you have all of your properties crossed and lending tangled. It also gives the bank more security and a less risky position.
There may be clients who understand the risks and complications and still opt to cross collateralise their loans. Some lenders offer a slightly lower rate for the lower risk and some clients do not want the third loan split that separating loans can cause. Personally I would never cross my properties, but I do have clients who choose to. I always ensure that they are educated before they make that choice.
If you'd like to learn more about cross collateralisation, get in touch with us at Sphere Home Loans for an obligation free chat today!
The Sphere Home Loans team