Cross-collateralization: How you can use equity to buy your investment property
Many property investors are unaware of cross-collateralization. But wrapping your head around this means of loan structuring - its pros and cons - can be an important part of developing your property investment portfolio.
So what is cross-collateralization?
This is when more than one property is used to secure a loan (or multiple loans).
Take, for example, if a person owns one property – but wants to purchase a second property without using any of their own funds. Well, the bank can use both properties as collateral for the new loan.
In actual fact, some investors can have these cross-collateralized loans without even realizing it. If you’re not sure, just check for details in your loan contract. You should find a section listing the addresses of the properties over which the lender holds or will register its mortgage.
What are the benefits of cross collateralizing?
- It’s good for beginners:
As a general rule – it can be a good way to start out in your investing journey! This particularly applies to those people with no plans to buy or sell any properties in the near future.
- You can potentially get a lower interest rate:
As in, you’ll be getting an owner-occupied interest rate on your whole portfolio rather than a (higher) investment loan rate.
Lenders will allow you to use your owner-occupied property and cross-securitize it with your investment properties. As a result, you may find yourself with a home loan rate, of say, 3.7% - in contrast to an investment loan with a 4.2% rate. That’s going to save you a lot of money in the long run!
- Tax benefits:
Despite the owner-occupied loan collateralization, you may still be able to claim tax deductions on your investment properties.
Actually, because you’re using equity to purchase an investment property at 100% of the value - the purchase might be 100% tax deductible.
Always remember, when it comes to these tricky tax issues, at OzBroker we always recommend having a proper meeting with a qualified accountant to sort out the best options for you.
- It can be a good strategy when downsizing:
Of course, a lot of investment properties are bought with the intention of selling a first home – and then downsizing.
Well, having the same lender and the same mortgage applying to both properties makes life considerably easier – particularly if you don’t have big investment plans. And by keeping a hold on the investment property for a couple of years, you can expect (according to reasonable financial estimates) to be able to uncross-collateralize.
What are the downsides to cross-collateralization?
Okay, so here are some of the issues you may encounter.
- Potential loss of your flexibility:
Unfortunately, it does give the bank more decision-making power. For example, with the sale of a property, the bank might determine the proceeds be used to reduce other loans in that portfolio (to keep the Loan to Valuation Ratio (LVR) within a certain level).
- Some Increased Complexity
Typically, whenever one property is released – every property in the portfolio needs to be re-valued.
This is undertaken for the bank to determine its exposure with any remaining properties. And that process might involve significant costs to you.
You’ll also find that new documentation (known as a Variation of Security) will be required every time a portfolio is changed.
- Limited Choice
In general, most property investors favor Interest Only loans. And it can often be a better strategy for the smart investor to use multiple lenders – thereby picking and choosing the best loans.
As an investor’s exposure increases with any one lender, that lender can restrict future loans to only Principal and Interest. Once your aggregate debt starts going up, banks will start looking to assert greater control over the type of loan(s) they offer.
- Changing Lenders can be Problematic and Expensive
When a loan is secured by multiple properties, the establishment fees are often higher as they include charges for ‘additional’ security.
That cost will only go up when an investor decides to move cross-collateralized properties from one lender to another. Exit fees can be pricey – and then there are the new valuations that might be required.
- Equity Access Complications
If one property in the portfolio has enjoyed a capital gain and the others have dropped in value, the net effect on the total value may be zero.
The equity in the property that increased in value is inaccessible to the investor because the overall equity in the portfolio didn’t increase.
This can have consequences. For example, it could mean that an investor does not have ready access to cash and may miss valuable investment opportunities.
If the loans were not cross-collateralized, an application to increase the loan or credit limit against the property that increased in value would be a relatively simple process.
Cross-collateralization: final take
We’ve said that we prefer separate loans and securities. But there are also scenarios where Cross-collateralization could be a good option.
For example, if you’re not in a hurry to move your portfolio and your LVR is at around 50-60% of the total portfolio value.
As with so much in life, every situation is different! At OzBroker, we’re here to help - please contact us for a consultation about the best options available to you.