Cross collateralization is a practice in lending that can be useful in some situations and should be added to every real estate investor’s repertoire. Read on to understand how this investment property financing strategy works and whether it is right for you.
Related: How to Get Your Finances in Order Before Buying an Investment Property
What Is Cross Collateralization?
Cross collateralization is a financing method where one property is used as collateral for multiple loans or multiple properties are used as collateral for one or more loans. Let’s look at how this financing strategy works in more detail.
This strategy can be classified into two types depending on the mechanism in which it is executed:
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Multiple loans are secured by the same property
The first form of cross collateralization occurs when one piece of real estate is pledged as collateral for more than one loan. A great example of this option is when a homeowner takes out a second mortgage or a home equity loan.
Related: How to Get a Second Mortgage to Buy Another Property
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Multiple properties cover one or more loans
Sometimes a single property may not be enough to secure the loan you want. In such a scenario, the lender may need you to put up more than one property to add more security to the loan. An example of this second form of is a blanket mortgage. This option is often used by investors using the same lender for multiple real estate loans to finance multiple deals at once.
If you are considering this financing strategy, it would be wise to find a lender who allows a release clause in the cross collateralization agreement. This allows you to refinance or sell individual properties in the future as you build equity in the properties.
You now have a good understanding of how this method of financing works. But is cross collateralization good for investors? Below we look at some of the major advantages and disadvantages of this financing route.
Let’s find out the pros and cons of cross collateralization for real estate investors
Pros of Cross Collateralization
Here are some reasons you might want to consider cross collateralization to finance your real estate investments:
1. Good financing option for investors with a bad credit history
A cross collateral loan can be a financing option for an investor with a poor credit score who doesn’t qualify for conventional loans. Lenders may be more comfortable approving such real estate for this loan if they have enough equity build up in their existing rental property or properties. Though not a common investment property financing option, cross collateralization can be very helpful to investors who are struggling to find other financing options.
Related: What Is a Good Credit Score? Everything Real Estate Investors Should Know
2. Potentially lower interest rates
Another advantage of this financing strategy is that you can get a much lower interest rate relative to conventional investment property mortgage rates. This makes it a more affordable financing option when buying a rental property.
3. Leverage
Cross collateralization provides investors with more leverage by allowing them to use the equity in their existing properties to purchase more income properties. You can use a cross collateral mortgage to finance multiple real estate deals at once.
4. Better tax benefits
Using a cross collateral loan (equity used to purchase 100% of the property’s value) allows you to claim greater tax benefits compared to getting an investment loan that is partially secured with your own funds. This lowers the effective tax applied and ultimately increases your cash flow and rate of return.
Cons of Cross Collateralization
Here are the main drawbacks of this investment property financing strategy:
1. Higher risk of foreclosure
While a cross collateral loan allows you to back up multiple loans with one or more properties, you risk losing them all if you fall behind on payments on any of the loans or file for bankruptcy. Should you default on one loan, it will be as if you have defaulted on all loans. The asset or assets used as collateral will be seized by the lenders to cover their loss.
Of course, the stakes are higher when multiple properties are used as collateral. You can lose multiple properties at once. To avoid losing the assets you’ve worked hard to accumulate, you will have to ensure that you stay on top of your loan payments or simply avoid this type of arrangement.
2. Difficulty in selling properties individually
When multiple properties are pooled to secure a cross collateral loan, it becomes difficult to sell the properties individually. You don’t get the same flexibility as a real estate investor with separate investment loans.
3. No access to equity in one property
If you have secured a single loan with multiple properties, you will be putting all your eggs in one basket since the properties are linked. A capital gain in one of the properties doesn’t mean much if the total value of the portfolio hasn’t increased. Some properties may have dropped in value and reduced the overall equity in the portfolio. If you had separate investment loans, you would be able to access the equity build-up in any of the properties to purchase other income properties or refinance.
When selling a single property or refinancing the cross collateral loan, all the properties have to be revalued. This can be a complicated, time-consuming, and costly process depending on the number of properties that are cross-collateralized.
Is Cross Collateralization Right for You?
Generally speaking, cross collateralization may be a good financing option for homeowners who want to take advantage of low interest rates, want to avoid having to use their own funds to acquire an income property, and don’t plan to sell any of their properties or buy more properties in the near future. This may make sense when you are just beginning to build your real estate portfolio.
However, as with all investment loans, there are potential risks that you need to take into account before moving forward. The increased complexity, loss of flexibility, and risk of foreclosure may make this financing route less desirable to some real estate investors. Nevertheless, every situation is different. Assess your risk appetite and be sure to speak to a mortgage broker about the investment financing options available to you.
The Bottom Line
If you are looking for a way to get affordable financing but don’t qualify for the best investment loans, cross collateralization can be an appealing option. However, taking on this kind of financing can be very risky. Make sure you fully understand the risks and even seek professional advice before taking on a cross collateral loan. Ultimately, whether this path is the right financing option for you or not will depend on the situation at hand.
Apart from choosing the right investment property financing strategy, investors should also ensure they buy the right investment property. The best way to find profitable investment properties for sale in the US housing market is to use Mashvisor’s real estate investment tools for your property search and analysis.
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