Cross Collateralisation

Best to avoid, but there are no hard and fast rules

Many self professed investment gurus decry cross collateralisation as the evil spawn of the devil (also known as lenders) and while we always agree that it is usually best avoided there are many times when it is unavoidable or counter-productive to avoid.

The Evil when a lender has your portfolio of multiple properties cross collateralised they well know that to break it up can cost you thousands in exit fees, refinance fees and loss of discounts and they often take advantage of this. So for example you may decide to sell a property that is not performing well in order to use the funds to purchase another property - but if that property has good equity the lender can and often will dictate that the proceed for the sale must be used to reduce your existing debt - rather than extend your portfolio. This can happen even when your equity position is below 80% - there are no laws that force a lender to lend to you just because you have the equity and can afford the loan repayments. They can and do say no - in the knowledge that a partial refinance can only proceed with their approval (they do not have to agree to discharge a mortgage when the property involved secures other mortgages) and they expect that a full refinance is a lot of effort and could be very expensive.

Cross-collateralisation occurs where several properties are provided collectively as security for a loan or several loans. In the diagram, the borrower originally had a loan on his house, but when he had build sufficient equity extended it to purchase a second (investment) property.  As a result the lender has control of the borrower’s entire portfolio of properties.

Separate collateralisation would generally be achieved by our borrower above by financing his second (investment) property with a different lender.

As will become evident below, there are certain quite distinct and in some cases very debilitating problems with cross collateralisation. These problems often arise well into the future and once the tangle of cross collateralisation exists it can be expensive to untangle. So if you can avoid it without incurring any costs or inconvenience, you always should. Give us a ring and we can help you avoid cross collateralisation, or if you are cross-collateralised explore options to uncross your properties.

On the other hand we know of situations where people go to lots of trouble and expense to avoid cross collateralisation. And quite frequently it’s not worth the trouble. This newsletter will help you work out how important avoiding cross collateralisation is to you.

To cut to the chase, our takeout is this. If you’ve got a steady income, expect it to remain so for a fair while and you want to steadily build your investment portfolio then cross collateralisation could save you time and money without entailing large risks. But if you aggressively acquiring property and like to push the envelope – stretching your serviceability and collateral to the max, or if you think you might not be in as favourable position as you are now in a few years but may want to go on investing, it may make sense to avoid cross collateralisation. And of course this is a summary – it depends on your circumstances – about which you may find more detail below. But remember it’s always advisable to get professional advice on your financial strategy.

Let me explain . . .
As a stand alone investor you will usually need to refinance an existing loan with a line of credit (or extend the loan – often with an additional sub-account to keep the borrowing between properties separate). That’s the way you access rising equity in your home so that you have enough to cover the deposit and acquisition costs for the new investment property. You can then shop around to find the best mortgage for the remainder of the property price, meaning you will have separate loans with separate lenders. Lots of self styled professional property investors will tell you that this is the only way to go.

Contrary to what you’ve heard, dealing with a single lender – often with cross collateralisation – can have distinct advantages in terms of cost and convenience – though the perils of cross collateralisation should also be borne in mind. So you need to think through the issues for yourself with a professional advisor rather than take anyone’s word as gospel. The case for cross collateralisation is fairly straightforward. Separate collateralisation means you’re likely to have more loan accounts. That can cost you more money in application and account keeping fees and if you want to refinance, the costs can be higher – attracting exit fees for each loan and settlement fees for each mortgage. Not only that but because lenders like to get all your business they make it cheaper for you. Professional packages tend to allow you lots of accounts without additional account keeping fees. And application fees are usually replaced by an annual ‘facility fee’ which means that the minor restructurings which can often accompany the purchase or sale of a property can be done without incurring an additional application or exit fee.

Then there’s the hassle. In the example of stand alone financing quoted above, you had to apply to two lenders – all that detail, all those documents and all that stress as you wait for settlement and hope that neither lender stuffs things up. With a single lender’s professional package you simply make one application and there’s often no additional application or account keeping fees at all – they’re all subsumed into your annual facility fee. We’ll get onto the situations where stand-alone finance might be best in the next newsletter. But here are a few myths that drive the push for stand alone finance.

Myth 1: Separate collateralisation helps protect your house.
There’s a bit of truth in this but only a bit. People think that if a lender doesn’t have a mortgage on your home they can’t sell you up. Not true! If Lender A has a mortgage on your home and lender B has a mortgage on your investment property and you are in arrears on your investment property then you can’t keep your home safe by just keeping up payments to lender A. Lender B has a right to the money you owe them. They’ll sell your investment property first. But if it doesn’t produce enough money they’ve got the right to keep coming – and indeed to sell all your assets until they get their money back. So much for separate collateralisation protecting your house.

The situation with cross collateralisation would be similar. You have two accounts with one lender and are in arrears with your investment property. The lender has the option to sell both your houses – and they’ll do it if necessary – just as either lender could if you didn’t meet payments to separately collateralised lenders. It is true that if you’re cross collateralised the lender could decide to sell your home when you’d rather they sold the investment property. If it was distinctly more saleable than your investment property it’s a possibility. On the other hand lenders don’t like being cast as the bad guy on A Current Affair.

If your investment property has enough equity for the lender to recover their loan on it, and it’s clear you can service your home, then the lender is likely to leave your house alone. Of course it can’t be guaranteed that they will. But then if your investment property sells for less than you owe on it, separate collateralisation won’t save you either.

Myth 2: Cross-collateralisation is unwieldy when you’re refinancing.
You might have heard it said that under a cross-collateralised structure you’ll be required to re-value all of your properties when the time comes to sell or add to your portfolio. This is because your equity is calculated on the value of all your properties combined. Not only is this costly and inconvenient, it can also place limits on the amount that you are able to borrow if one property if one particular investment has not performed well.

It’s certainly possible and we’ve known clients to whom it’s happened, but cross collateralised lenders will often do the commonsensical thing and simply value the properties you believe will have risen in value since the last valuation. And guess what? That’s exactly what the story would be if you were separately collateralised.

Myth 3: Cross-collateralisation ‘locks you in’ to a lender.
This is really the nub of the whole issue. In principle cross collateralisation does lock you in, but remember if you read any normal loan contract, the rights it gives the lender will make your hair stand on end. They typically have the right to demand a whole range of things – from revaluation to their capital back (generally requiring you to sell up or refinance) at their behest. They don’t do it of course because they’re trying to make money by keeping you as a customer, not by handing you over to the opposition.

But it is true that the use of a single lender for your whole portfolio gives them lots of power over you – in theory anyway. But – and this is the crucial bit – given that all lenders have all sorts of rights you would rather they didn’t have, your real power comes not in the contract with them but in their desire to compete and your concomitant ability to refinance to another lender.

Busting the Myths. Your power to negotiate a better deal is a function of your ability to refinance! So long as your power to renegotiate a better deal is in tact you’re in pretty safe hands. Firstly because you’ll get the instant attention of ‘client retention units’ inside lenders when they get wind of your intention to jump ship and secondly because in the event that you don’t we can help you get it from the new lender you’ve chosen. But that involves exit fees I hear you cry! Indeed it does, but so too does refinancing with lots of stand alone loans. And guess what? Because loan structures are usually more complex and there are more loan accounts with stand alone finance, and because they’re often not aggregated into ‘professional packages’ we know of lots of instances where it costs lots more to comprehensively restructure a portfolio of loans obtained through multiple lenders.

By contrast completely refinancing a professional package often costs around $1,000. Not fun to pay but, so long as you don’t trigger your state’s stamp duty on finances, a quite minor expense and not one that should stop you rearranging a large portfolio of loans given the size of the benefits one is usually targeting with such an exercise.

And before I go I think it’s worth mentioning that we can get you the best of both worlds – finance through one lender but without cross collateralisation. Give us a ring if you’re interested and we can talk you through it.