Neutral Bay resident, Kylie asks
“What is cross collateralisation, and what exactly does it mean?”
Great question Kylie.
Cross collateralisation might sound confusing but it’s actually quite straight forward. Here’s a brief explanation to help you understand what it means and how it’s applied within the financial marketplace.
Cross-collateralisation (also known as cross-securitisation) is when more than one property is used to secure a loan or multiple loans.
A typical example would be someone who owns their own home with sufficient equity in it and who wants to invest in another property. You could potentially finance 100% of the purchase price of the investment property plus the purchase costs.
Since it is generally not possible to borrow 100% of the value of a standalone security, you need to offer a second security for the loan. In this instance, that loan of a 100% of the purchase price of the property would be secured by the investment property being purchased and the existing home. Ultimately you have one loan with two different security properties that are ‘tied’ together.
What would you have to do in order to qualify for a loan of that type?
The bank will generally do a valuation on the existing property and the investment property.
The amount of equity you have in the existing property will partly determine how much you can spend on the new property. The lender will combine your two mortgage totals, that of your existing loan and the new loan, and divide the value of the two properties. This evaluation process looks at the transaction as a whole. For example, if your existing loan plus the new loan amount to $800,000 and the two properties add up to a million dollars in value, which means you will be borrowing 80% of the total value.
What is the alternative to cross-collateralisation?
Instead of borrowing 100% or more of the purchase price of a property in one loan secured by 2 properties the alternative is to borrow the funds using 2 separate loans as follows:
- A loan equating to 80% of the purchase price of the investment property. This is only secured by the proposed investment property. You can borrow more than 80% but it will generally incur lenders mortgage insurance.
- A loan equating to 20% of the purchase price of the investment property plus additional funds for stamp duty. The sole security is your current property.
Using this structure will still allow you to borrow the same overall loan amount of 100% of the purchase price plus purchase costs but in 2 separate loans each with just one property as security. Although the loan of 20% plus costs may be secured by your owner occupied home the interest on that loan is still generally tax deductible since the purpose of the loan was to purchase an investment property. Always seek the advice of your accountant when determining what interest you can claim as a tax deduction.
What are the downsides of cross-collateralisation?
Cross-collateralisation involves two or more properties securing one loan. While you may be wondering if this is how investors grow their portfolios, it’s possible but certainly not the preferred method of financing an investment property portfolio.
The alternative is that you have each loan secured by just one property and not multiple properties.
Some reasons why I believe it is best to avoid cross-collateralisation if possible include:
- If you want to refinance just one of your properties to another lender for a reason such as a cheaper interest rate it is much easier to do this if the property is a standalone security. Your existing lender will require you to complete a partial discharge form if it is cross-securitised, and depending on the value of the property(s) you aren’t refinancing you may be required to pay down your existing loan to a level acceptable to the bank to remain within their Loan to Valuation (LVR) policies.
- If you want to borrow against the equity in the future it is likely a valuation of the property will be required. If the property is a standalone security only one valuation is required. It is much less complex and time consuming to value one property rather than multiple properties
- If you have multiple properties cross-collateralised, and you wish to sell a property, it is likely the lender will require a valuation to be done on the property not being sold and will then dictate to you how much of your sale proceeds have to be paid off the loan in order to remain within their Loan to Valuation (LVR) policies. You would also be required to complete a partial discharge authority in order to release the property being sold.
- One of the biggest considerations of cross-collateralised properties is that in the event that either of the properties decreases in value it could negatively impact your ability to borrow against equity in the future. This in turn could impact your ability to continue growing your portfolio. When security properties are cross-collateralised the lender will generally value both properties. If one property has decreased in value it could effectively wipe out your ability to borrow more money. Even if the other property has increased in value this could still be the case. On the other hand, if the property that has increased in value is a standalone security you could apply to borrow against that equity. The other property that decreased in value would not be involved in the transaction.
Get in touch with us
If you’re interested in speaking with us about cross-collateralisation, or you want some help in converting your properties into standalone securities, please get in touch. We have a range of various options to suit your needs. Call us today and speak to either myself (Patrick) or one of our loan advisors.
We look forward to speaking with you.