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The Dangers Of Cross Collateralisation

The Dangers Of Cross Collateralisation

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’

stopit

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.

Wrapping Up

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.

Credit Card Trick To Knock Off Thousands From Your Interest Repayments

Credit Card Trick To Knock Off Thousands From Your Interest Repayments

SHOUT-OUT: This post was inspired by reddit user ‘CallMeSobriquet’ who wrote a great piece on /r/fiaustralia

 

If you have a home loan in Australia at the moment, odds are your interest rate is sitting anywhere between 4-6%.

As I’ve already mentioned before in how much does it really cost to buy a house, interest repayments for a loan over 25+ years can sometimes cost more than the actual house.

Ain’t that some shit?

 

There are a few ways you can lower the costs of interest repayments:

  • Refinance to another bank at the lower interest rate
  • Pay off the loan quicker
  • Dump money into an offset account

What’s an offset account? Basically an account that reduces the principal that the banks calculate the interest repayments on.

Say you have a loan for $100K and the interest rate was 7%

You would have to pay $7K in interest every year.

If you had the same loan and interest rate but also had an offset account with $20K sitting in it, the banks would calculate your interest repayments in the following way:

Loan amount ($100K) minus offset ($20K) * 7% =  $5,600

You essentially saved $1,400 bucks of interest repayments by just having your spare cash ($20K) sitting in the offset account.

Mr_Burns_Excellent

 

Enter Credit Card Tarting/Stoozing

Some credit cards in Australia have the ability to transfer the balance (usually up to 80% of the credit limit) to another banking institution without a fee.

This is relatively unique to Australia and whilst I have read some other country being able to do it, it seems like most banks overseas won’t allow you to.

Credit card tarting/credit card stoozing is where you basically use a credit limit that has a 0% interest free period and dump that amount into your offset account to lower your interest repayments on your home loan.

Here’s a break down on how it works:

  • Open a low or zero fee credit card with a financial institution different to the main bank where you hold your home mortgage loan and mortgage offset account. You also need an existing credit card with your main bank.
  • When applying, ask for the largest credit limit they’ll give you.
  • Immediately balance transfer the maximum amount to your CC in your main bank, and then internally transfer this to your mortgage offset account.
  • Set up an automatic monthly payment from your mortgage offset account to the new credit card for the minimum repayment amount the card requires (usually 2% of the current balance).
  • You’ve now effectively got yourself a fee-free one-year loan at 0% interest, which you are using to offset (tax free) your mortgage!!!
  • One month before the interest-free period on the balance transfer expires, transfer the entire amount back from your mortgage offset account to the new credit card, and either (a) close the CC account, or (b) ring the bank and ask them to give you a new 0% balance transfer on the same card.
  • Wash, rinse, repeat.

 

How Much Could This Actually Save You?

Imagine that you and your partner both applied for CC’s with a max credit limit of $50K on each.

Following the strategy you both transfer 80% of the combined balance ($80K) into the offset account that is offsetting your home loan of $400K that currently has an interest rate of 7%.

Without the offset you would be paying $28K in interest every year

With the extra $80K offsetting your loan you would now be paying $22.4K in interest!!!

That’s $5,400 dollars every year in interest repayments saved without paying a cent!

And who said there’s no such thing as a free lunch?

Credit_Card_Tarting_Homer

Things To Be Aware Of

  • This strategy works best if you have a home loan. You could transfer the money into a high savings account and make money instead of saving it on interest repayments. But the interest rate on a HISA is lower than a home loan and you would have to pay tax on money earn’t so it’s not as effective.
  • Need to be earning a high income and have good credit rating. The bigger the limit is on your CC the better. And to get a big limit you usually have to be a high income earner with little debt already.
  • This may affect your credit rating! This is a big one. Applying for too many CC’s can negatively affect your credit rating which could affect your ability to get credit in the future such as home loans.
  • MUST STAY ON TOP OF THE GAME! If you stuff something up like not reading the fine print on balance transfers or missing your interest only period this strategy can very quickly cost you more than it saves you. You must  be on top of everything. Not that hard to do but the banks are aware of credit tarting and the only reason they allow it is because they have statistical data that says that even though this is possible, odds are that the majority of people won’t have the discipline to stick to the plan and will end up paying more in fees than they save.
    Have you ever wondered why CC’s offer big sign up bonuses for free even if you cancel the card straight away? What’s the catch right? There is no catch, they just have the data that verifies that the majority of people are not financially savvy enough to stick to their budgets and they will most likely blow out their spending of their CC and incur CC interest fees which is where the banks clean up! They would much rather be charging you 22% (CC rate) interest than 7% (home loan rate) and are willing to give out freebies (CC sign up bonuses) in order to suck you into the trap.

Conclusion

Credit card tarting can be an easy way to ‘beat the system’ and knock thousands off your interest repayments, but to the undisciplined home owner who is not prepared to strictly stick by the plan it can end up costing you more than what it’s worth…
Photo credit: Sean MacEntee via Foter.com / CC BY

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