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Cross-collateralisation

Wednesday, 2nd May 2012
Categories: Finance, Newsletter

lenders

Cross-collateralisation can greatly jeopardise investors’ property plans. But what exactly does it mean and how can it affect your investing potential?

Lenders generally want to get their hands on everything you have.  You will find out that they will want security not only on the property you are purchasing, but also on your own home, your car, your first born child and your dog.  Well, they won’t really ask for your first born child and dog, but they might take them if you offered.

Cross-collateralisation is where more than one property is used as security for a loan.  Cross-collateralisation should be avoided as much as possible as it will limit your ability to borrow further funds if another financial institution has some type of security over the property you are trying to borrow against.  Unfortunately most novice investors do not understand the restrictions cross-collateralisation puts on your wealth creation strategy.

For example, let’s assume you own your own home worth $600,000 and you have a $200,000 mortgage.  You have no free cash available.  You decide to purchase an investment property for $400,000.  You would go to your current lender and say, “please lend me the entire $400,000”.  Given the amount of equity you have in your home, they should loan you the entire amount, and they will take first mortgage security against both properties.  You have purchased an investment property.  You now have both your properties tied up to the one financial institution.  You also have $1,000,000 worth of property and $600,000 worth of debt.  You have at least another $200,000 of equity in those properties you could obtain for further use (based on an 80% loan to value ratio LVR).

If you were to ask for a loan for the additional $200,000, who do you think will lend you the money?  Probably you’re current lender, but perhaps not many other financial institutions.  Financial institutions hate second mortgages.  They aren’t in control and don’t get to keep the property title as security. This is held by the first mortgage holder.  Therefore in this scenario your best chance to get another loan is with your current lender.  The trouble is that they now have already lent you $600,000.  If they say “no more money” you have to accept that or refinance that financial institution out of all the property you hold with them and start the search for finance from scratch.

Successful investors know that it is wise to spread your borrowings around amongst different lenders.  In this example we just reviewed there would have been a better way to get all the finance you needed.  Firstly you should go to your current lender (or find another) and say “Mr Lender I have a property worth $600,000, my mortgage is $200,000, I want a home equity loan with redraw for another $280,000”.  If you have good credit there is no reason why you should not get this money.  Suddenly you have a $280,000 facility available.  You purchase the $400,000 property.  You come up with a $80,000 deposit from your redraw account and go to another financial institution.  You say “Mr Lender, I have purchased a property for $400,000.  I want a loan for $320,000.  Please give it to me now”.  Assuming your credit is fine there should be no reason why you wouldn’t get this loan.  You now have $1,000,000 worth of property.  You have two lenders who both only control one of your properties.  You also still have $200,000 left in your redraw account with which you can purchase more properties or other investments.  You could buy another $800,000 worth of properties with that $200,000 redraw account, or you could invest it into the share market or any other investment you decide.

Having different mortgages and different lenders on each individual property also gives you many more options should you choose to refinance.  For example, if you have all your loans with one institution and they reject a new loan application, you are going to have to refinance all your properties with someone else.  If it relates to one property only, you can just refinance the one property and keep all your other loans in place.

Each property you purchase should be assessed on a stand-alone basis only.  You should only offer as security the property you are purchasing.  If another property is cross collateralised it will limit your borrowing ability.