If/when you get to a point in your life where you own multiple properties, you will no doubt come across the term ‘cross collateralisation’. It’s a very important loan structure issue that you must fully understand if you ever do decide that it’s the best option for you. Many mortgage brokers (my first included) don’t actually understand the full implications themselves and are more than happy to sign you up for it because it’s usually an easier process. Cross collateralisation can very rarely be a good option, the majority of the time it simply increases the investors risk and strengthens the banks position of power.
Cross Collateralisation Explained
Cross collateralisation is when you use house A as security for purchasing house B.
Lets look at how you buy a house in the first place. THE most important thing when buying is….THE DEPOSIT! Banks love that shit. If the deposit is big enough you can pretty much guarantee that the bank will approve your loan.
No Job? No Education? No prospects?
Got a huge deposit, no worries. (I’m talking like >70% here guys)
It’s important to understand what the actual deposit means to the banks. It’s their way of lowering their exposure to risk.
Think about this. If you buy a $400K house with a 20% deposit that means the banks lent you $320K. Worst case scenario for the banks is you default on your loan and they are forced to sell to recoup their investment (the loan). They are not worried in the slightest about making money from this property, they just want their money back asap.
Ever wonder why you always hear of these stories of foreclosure bargains? It’s because the banks could not give two shits about an extra $10K, $20K or $40K. That’s pocket change to them. They just want to get back what’s theirs.
So now they have this house which the owner paid $400K for. Unless there has been a big downward swing in the market you would surely think that the banks could at the very least sell it for somewhere near the $320K mark. If they do then relatively no harm done, they loaned out $320K and got back their investment. No money made but minimal lost…except if you’re the poor sod that applied for the loan. You’re probably down the shitter now but like the banks care right?
So as you can see, the deposit is king to the banks and without a decent sized one (at least 20%) you are likely to pay exuberant fees to get the loan approved.
So why have I explained the above? Well as I have already mention, deposit is king. But what if I told you there was a way to get a loan approved without having to fork out one dollar? With the flick of a pen you can have access to hundreds of thousands of dollars.
Sounds too good to be true.
Enter Cross Collateralisation.
No Such Thing As A Free Lunch
Cross Collateralisation uses equity as the ‘down payment’ instead of cold hard cash. To simplify things, lets assume we have $200K of untapped equity on our family home (House A). We want to buy House B for $400K but don’t have a deposit.
To secure the loan we can use the equity from House A as collateral. This essentially does the same job of lowering the banks risks, just utilizing a different method.
House A Loan: $300K
House A Value: $500K
House B Loan: $420K (loan includes 5% buying costs)
House B Value: $400K
Security: $500K + $400K (the value of both properties)
LVR : $300K + $400K = $700K
. $500K + $400K = $900K
= 77% LVR (loan value ratio)
There will be a section in the loan contract that details that this loan is secure using another property over which the lender holds it’s mortgage.
‘Wow that’s pretty cool isn’t it? Didn’t even have to save any money to buy another property and the banks made the loan contract a breeze. I’m going to buy all my properties from now on using this method’
You must consider the ramifications first.
1. Selling Headaches
Every wonder what happens when you want to sell the property that you used to secured the others?
To put it simply…Whatever the bank decides is going to happen.
They have complete control over the proceeds of the sale. I hope you didn’t have anything planned for the money you were going to get when you sell House A. Because the bank has just decided that House B is at a higher risk than when you first bought it and now requires your loan to be at 70% LVR. So that $200K you just received is going straight to the loan on House B…Nothing you can do about it.
And if you think that’s bad. Imagine a situation where you have secured multiple houses with multiple other houses…shit show.
2. Equity Withdrawals
At the moment, if I want to withdraw equity from one of my properties it’s super simple. I apply for the withdrawal and as long as I’m keeping it under 80% LVR there are minimal hoops I have to jump through. I’ve done this three times now (once for each of my IPs) and it’s been very straight forward.
There has been times though where one of my properties have gone up in value and the others have gone down. Because my properties are not cross collateralised I am able to access the equity from the IP that went up because they are seen by the banks as separate .
If you have all your properties cross collateralised however the bank views all of them as the same. You might have had one IP go up by $50K but the others go down by $30K each. This would mean you can’t access the equity on the one that went up which may impact your opportunities moving forward.
3. Want To Swap Lenders?
‘Hey look at that! CBA has been ripping me off with their high interest rate. I’m going to move all my loans to the lower rate at Ubank’
People do this all the time. The problem with Cross Collateralisation is that you can’t just move one or two loans across. You have to either move everything or nothing. Depending on who you’re going to they may not want that level of risk exposure. They might charge extra fees for having to value all the properties to determine the position.
In short it’s a pain in the ass for a process that is so much easier for stand alone loans.
4. Complicates Things
The extra paper work you have to complete only increases the more you cross collateralise.
Want to sell? Complete evaluation of your entire portfolio (assuming you have cross collateralised your entire portfolio).
Want to withdraw equity? Complete review of your financial position on all properties.
Want to move banks?…. You get the picture.
What To Do?
If you discover cross collateralisation exists in your portfolio without you even knowing it (happens all the time) there are a few things to consider.
Cross collateralisation isn’t a problem… until is it.
What I mean by that is that it’s perfectly fine to cross collateralise if nothing goes wrong. But the odds of something undesirable happening increase when you cross collateralise and it usually only benefits the bank.
If you want to uncross your loans go see a mortgage broker who can assist you and work out a plan of attack.
Stand Alone Loans
You really want all your loans stand alone. The only advantage I really see for cross collateralisation is the convenience of setting them up. The banks really like to strengthen their position so they make it super easy to cross collateralise.
The thing is, if you have equity. You can withdraw the equity as cash and use that cash as a down payment for a new loan. I have utilized this method in the past and have had great success with it.
You have to check with your lender on the conditions for equity withdrawal but if you can do it, it’s a much smarter way to buy your next investment as opposed to using cross collateralisation.
Cross collateralisation may be convenient and appealing for investors looking to buy a new property without using their own money. However, cross collateralisation rarely is a good thing and the majority of the time it does nothing but cause headaches later down the track. The banks prefer cross collateralisation because it strengthens their position of power and they have all the control.
If you have equity available, look to withdraw this equity as cash to use as the down payment for the new loan. You might have some short term pain with a bit more paperwork and a few more hoops to jump through but your future self will thank you for laying the foundations of a strong portfolio now rather than later.
Hey there Firebug, I’m one who has used this form of borrowing and security to purchase investment properties and have to say that it actually works very well in a bull market which is when I was buying.
I originally used the equity on my own home as the deposit on an investment property and subsequently, over about 5 years, built up a portfolio of 5 properties that I never used a cent of my own money to buy and have paid for themselves ever since.
As I say, this works best in a bull market as the value of each property is increasing and therefore giving more equity to use as a deposit on the next purchase. However, as you say, there are definitely risks and should the bum drop out of the market, you could be left in deep shit if suddenly the revised value of your properties doesn’t fulfil the bank’s loan to value ratio.
I did well out of it but that has been due to some caution and not over-extending myself and some luck that the market has boomed.
My advice to anyone considering doing this is make sure you do your research and play the game with some caution. Great post mate.
Hey Martin, wow 5 IP’s! That’s awesome!
Yeah I know a heap of investors that have used this method to become extremely wealthy.
Question for you though. If you could do it again knowing what you know now…Would you still X-Col or withdraw equity as cash to use as the deposit and have standalone loans?
Hey again Firebug, I’m down to 3 properties now as they are all in Auckland and I’m in Brisbane so it’s a hassle I can do without as well as the expense of management fees.
Yes, it is a means to accumulate assets with little outlay if managed well. At one point I had a mortgage well into 7 figures but it was all managed. The key to using this method is to buy properties with good capital gains as the wealth creation only comes through the accumulation of gains through organic growth.
Would I do it again? Absolutely, if I could buy well priced property in a market that showed signs of growth.
The other issue with stand-alone loans is that you need to have the deposit in cash for each purchase which is not possible for many small time investors like me.
Thanks for this article. I don’t have an IP, unlikely now to ever jump in, but I’ve always been concerned about using equity in our house. If everything goes belly-up, I’d always want a roof over my head. I guess that is an indication of my risk tolerance. Your first point was an eye-opener for me – I’ve never considered what might happen if you wanted to sell the secured property.
No worries, glad I could help.
Your article was great but what about when it applies to a family home rather than an IP? For example, should I be concerned if I am intending to use the equity in an IP through X-Col to secure a loan for a family home? My intention is to eventually sell the IP in years to come and use that money to pay off the family home (which I imagine is exactly what the bank will direct me to do with that $ anyway). Is the benefit to keeping these loans separate that it gives me the option later on to move the money from the IP elsewhere? I thought that by withdrawing on the equity from the IP as cash then my IP loan increases however I can only utilise tax breaks on the part of the loan that is for the IP itself. Would love to know your thoughts, thanks.
You are correct that in the event of a sale from the IP that you used to X-Col your family home, the banks would firstly use the sale proceeds to pay off the original debt and most likely use the left over to pay down your family home debt.
The only thing I could see going pear shaped here is in the extremely unlikely situation that your IP goes down considerably. Consider this scenario:
Your IP is worth $200K with a debt of $100K giving you $100K of equity
You want to buy a family home for $500K and use the $100K equity as X-Col to do so
You now have two properties X-col worth a combined value of $700K with an attached debt of $625K (5% buying costs for family home added to $500K)
That would give you a LVR of 89%.
Now imagine that your IP halves in value (not likely). Suddenly all that equity is gone! And you now owe more that what your assets are worth. But wait there is some good news…your family home has actually increased in value by $50K! But now the banks have decided that your IP is far too risky because maybe you have bought in a mining town and the mine has shut. Your family home is now the one that has some equity and your IP is continuing to lose value every week!
What to do?
In this situation the banks can actually force you to reduce your LVR by any means necessary… And unless you cough up the cash…that means you could be forced to sell your family home to reduce your LVR.
This is HIGHLY unlikely but could happen. It becomes more of an issue the more houses you X-Col with each other.
That’s one benefit. At the end of the day it’s as matter of why wouldn’t you keep the loans separate? It may be a bit of extra paper work and honestly if you’re only going to X-Col two properties and you are financially responsible, you’re most likely never going to run into the issues I have highlighted above. But why take the risk?
Your IP loan does increase that is correct. And it is also correct that you can only claim interest for investments so that amount you withdrew to use as down payment for your family home cannot be claimed…BUT! This doesn’t really matter does it?
Using the example from above we could X-col our IP and take out a loan of $525K of the family home and keep the IP loan at $100K giving the total amount owed at $625K.
But if we withdraw the $100K as cash and use it as down payment. Our IP loan increases $100K to be $200K but our loan amount for the family home decrease to be only $425K ($100K deposit plus buying costs) giving a total amount owed to be the exact same of $625K. It’s just that the loan on the IP has increased in this scenario and the loan for the family home has decreased.
Both situations are the same as far as tax deductible interest is concerned.
I hope that helps a bit 🙂
I’ve got a cross collateral loan (didn’t even know it was called this up until now) and there is a couple benefits I think you should include in your overview.
$25,000k loan against my primary residence, borrowed to finance an IP.
Benefit 1 – that $25k is considered a residential loan by the bank, so they’ve given me a lower interest rate
Benefit 2 – that $25k is considered a business loan by the ATO – so I can claim those interest payments as a loss come tax time.
If I wanted to sell one or both of the homes, I imagine it would be lot more difficult than if the loans weren’t linked, but for a buy-and-hold strategy, there are other benefits.
Are you actually withdrawing $25K from your residential loan to get the interest rate discount?
I do the same thing as PA, small loan against my PPOR for around 25% for deposit and costs, and 80% mortgage against the IP. But that’s not a cross collateral loan.
When I bought my first IP, I took a 105% mortgage that was cross collateralised, against my home. When I tried to buy a second IP ALL properties had to be valued. The bank valued our first IP at 100k less than we paid for it, 2 years after we had bought it, we disagreed, but they would not budge. At same time we were told a new rule came in that they would only lend 70% on that property as they were overexposed in our building. So we did not have enough equity in our PPOR according to the bank. If we had taken an 80% loan for the first IP, and financed the rest as a seperate loan they would not have revalued the first IP, which led to the flag that they were overexposed, so we missed out on buying. 6 months later we refinanced across to NAB and undid all cross collateral loans, and bought again. NAB revalued the unit at 50k more than we had paid for it and were prepared to lend 80%. Gah Banks, don’t get me started! 🙂
I know I am a little late on this but I have been put in a position to take this X-Col option due to my Prop A being an owner occupied investment. If I use the equity from Prop A to put a deposit for Prop B, the income I gain from the renting out Prop (As investment) isn’t a tax deduction. Thus this X-Col option seems to be a better idea.