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How To Finance Investment Property - Articles

The Dangers of Cross-Collateralisation

Date: 26/02/2015

A common strategy for property investors is to use existing equity in either a family home or investment property to acquire new properties. Tapping into this equity can help investors build wealth more quickly while avoiding the capital gains tax triggered by a sale.

Rather than using a mortgage broker who represents multiple lenders, many investors will return to their preferred bank to gain the finance for their next deal. Without realising, some unsuspecting investors end up in a situation that highly favours the bank, but offers them little benefit. Instead of structuring the new loan to stand independently from the original loan, banks often prefer to tie them together.

What is Cross-Collateralisation?

cross-securitisationCross-collateralisation is when the collateral for one loan is used to secure another loan. Also called cross-securitisation, this practice provides extra security for the lender, but less flexibility for the borrower.

If the borrower is unable to make the repayments on any of their cross-collateralised loans, the lender can force the liquidation of some of the assets, and use the proceeds for repayment of the loan.

While some property-investing educators have trumpeted the tax benefits of an all-in-one cross-collateralised line-of-credit, the truth is, agreeing to this path can end up being highly problematic, at best. At worst, during a difficult season you could end up putting your entire portfolio of assets at risk.

Why You Should Avoid Cross-Collateralising

Here are four reasons why it’s best to avoid cross-collateralisation:

1. You may Find It harder To Access Your Equity Next Time

Find It harder To Access Your Equity Next Time

The primary reason to refinance is to tap into the growth in equity in a particular property. Sometimes, one property in your portfolio may appreciate in value, while others may depreciate.

When properties are cross-collateralised, the bank doesn’t care solely about the change in value of one property, but that of your entire portfolio. If the bank sees a zero net change in the total value of your property portfolio, they will more than likely knock you back on your request to access the new equity.

This would amount to a significant loss of flexibility for you, diminishing your availability to cash,which can result in a loss of an investment opportunities. If the loans were not crossed, and with different banks, the properties that depreciated would not even come into question. The lender would have no knowledge of the performance of these other properties.

2. The Bank Has Too Much Control Over Your Property Transactions

apply for a loanWhen you apply for a loan at the bank, the bank will naturally work in its best interest, as well as the interest of its shareholders. Their goal is to reduce their risk in every deal as much as possible.

The bank likes cross-collateralising your portfolio, because it affords them the greatest amount of power to transfer their risk to you, the borrower. Sometimes this can severely limit the way in which you use the sale proceeds.

Here is an example: Let’s assume you decide that it’s time to sell Property A, which is also secured by Property B. Property B has dropped in value, so selling Property A would leave the remaining property with a Loan to Valuation Ratio (LVR) that is not acceptable from the bank’s perspective.

Before the bank releases the title for Property A, they would require you to pay down the loan for Property B. This brings the LVR to within an acceptable limit. In this case, the investor would have no discretion over the use of the sale proceeds.

Cross-collateralisation can greatly restrict your freedom. It leaves you powerless to make the decisions you believe are best for achieving your wealth creation plan.

3. Changing Lenders Can Be More Difficult And Costly

higher establishment feesOne of the benefits of investing in a competitive lending environment is having the confidence to know you’re always going to get the best deal.

From time to time, it’s good to shop around and see how your lender’s interest rates and service stacks up against the competition. You could save a lot of money, as I wrote about here.

But if your loans are crossed, then you may find that you’ll have less leverage with your bank. Since they have control over your assets through your package of loans, they understand the challenges you’ll face in shifting your loans to another lender.

When cross-collateralised, the process is more tedious and costly. Not only would you face higher establishment fees, but the exit fees can be expensive, as well. Plus, any time you want to shift properties out of the mix, the bank will want to revalue your entire portfolio.

These valuations are undertaken for the bank to determine its exposure with the remaining properties, and each valuation costs you money.Depending on the number and value of your properties, this could amount to as much as $700 to $800 or more per property.

4. If You Happen To Default, Your Assets Are At Greater Risk

RiskLet’s face it. Sometimes people overextend themselves and go through difficult situations. If you face a worst-case scenario of default on a particular loan, you obviously want to minimize its impact on your overall portfolio of assets.

If your loans are cross-secured, the bank could take any property you offered as security, and sell it to cover their losses.

If your properties were on standalone mortgages, you would still be required to pay back the money you owe, but you would have greater freedom to choose how you would do that. Besides, who would be more likely to get a better price for your property, you or the bank?

Of course, the bank could obtain a court order to force you to sell the other property. But, this would require them to go to court first to acquire a judgment against you. They would then have to file separately again to obtain a court order.

The Right Way To Access Your Equity

There are rumours going around that all banks require cross-collateralisation. This is simply not true. Most times, this is the result of an uninformed investor who seeks lending from a banker who is either lazy, or who is purposefully minimizing the risk of the bank.

Therefore, you may have cross-collateralised loans without even realizing it. One way for you to be sure is to check the details of your loan contract.

Look for a section in the body of the contract that notes the addresses of the properties the lender is holding as security. If there’s an additional property listed other than the one for which you obtained the loan, then you are cross-collateralised.

Right Way To Access Your EquityIf this turns out to be the case, you can get the properties uncrossed, but it will take some effort on your part, and it can be a royal pain. Depending on the LVR requirements of your bank, you may also need to put up some cash.

As you continue to grow your property portfolio, you want each property to have its own separate loan attached to it. It should stand alone, being secured only by the asset itself. Therefore to release equity for the purchase of another property, you’ll need to separate the equity from the original loan.

Here’s an example of how it works:

Let’s assume you’ve owned an investment property for 10 years. You originally paid $400,000 for this house, but it’s now worth $600,000. Having put up $80,000 of your own moneyas a deposit on an interest only loan, you still owe $320,000 for this property. This leaves you with $280,000 in equity.

You have no other cash, but you want to buy another investment property. If you’ve completed Steve McKnight’s Property Apprenticeship course, you’ll have the confidence to buy a property to renovate and subdivide. Now you’ve found a suitable property for sale and go to see your broker.

Because you understand the dangers of cross-collateralising, you insist on keeping this new property separate from the existing loan. The bank has agreed to refinance up to 80 percent of the value of the original property. You take this $480,000 from the bank and pay off the existing $320,000 mortgage, while placing the remaining $160,000 in an offset account.

You now owe $480,000, secured by your original property, and have $160,000 cash for you next down payment.

down paymentYou then gain pre-approval, subject to serviceability, to borrow toward buying any property valued up to $500,000, using $100,000 of your cash as a deposit and the other $60,000 to cover the renovation and subdivision. This loan would only be secured by the new property you purchase.

Once you purchase the new property,you have one loan of $480,000 secured by the original home, and a separate second loan of $400,000 secured by the second property.All your surplus cash sits in the offset account to lower the interest expense of the original property.

Because each of these loans are completely separate and secured only by their underlying asset, you have the freedom to sell or refinance either property at any time without the other property coming under the scrutiny of the bank.

Conclusion

Banks want you to cross-collateralise all your properties,because it reduces their overall risks. There is no value or benefit to you, so avoid cross securing your loans, unless there is literally no other way to get the deal done.

We’ve only just scratched the surface on how to obtain the ideal finance arrangement for your investment property purchases. In Steve McKnight’s Property Apprenticeship course, we offer four separate sessions on property finance:

Part 1: The Lending Industry and Applying for a Loan

Part 2: Lenders and Mortgage Brokers

Part 3: Dealing with Lenders

Part 4: Joint Ventures and Partnerships

If I can answer any questions you have about our training options, feel free to get in touch with me personally through the PropertyInvesting.com office.

Profile photo of Jason Staggers

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.

Comments

  1. topgun21

    That sounds like really good advice but when I went to the banks they wanted me to use both my properties as security for the loans. They said I didn’t need a deposit if I did this and I could easily grow my portfolio too. Do you think I should do something now or wait until I get another property?

  2. Profile photo of Benny

    Nice one Jason!! :)

    You mentioned the “if things went wrong scenario” and a major outcome COULD be to have the Bank looking for where most of your equity is. That would likely be your Home Loan, wouldn’t it? i.e. When investing, we often use Interest Only loans for IP’s, while paying down our PPOR.

    So, if things went sour, could it be that your own home would be the “target of choice”, simply because it would likely offer the most available equity?

    Is it better to have your PPOR with a separate Bank? That is how I started out. That way, there would be NO CHANCE of having your PPOR cross-colled.

    And to Topgun21, this quote of yours is worth focussing on :-
    Topgun>>>> That sounds like really good advice but when I went to the banks they wanted me to use both my properties as security for the loans.
    Benny>>> That CAN still happen WITHOUT being Cross-collateralised!!

    Topgun>>>> They said I didn’t need a deposit if I did this and I could easily grow my portfolio too.
    Benny>>>> Make sure they have two separate loans rather than ONE big loan.

    You would need an 80%(?) loan on the new IP (one loan for that), leaving you to find 20% plus costs by using the equity in your PPOR (and a separate loan for that too). These loans should both be separate from any existing PPOR Loan too (you want the investment loans against your PPOR to be tax-deductible, right?) and DEFINITELY a separate loan from the IP loan.

    So, for many buying their first IP, this should have 3 separate loans, NOT ONE BIG LOAN with both properties as security.

    Many on here (including Jason) can give chapter and verse on Financing – and it is a HUGE subject. Check out the Articles and forums for more….

    Benny

    • Profile photo of Jason Staggers

      Equity grows not only through paying down a mortgage but through generic growth in the market. Most people tapping into equity in investment properties have seen some growth over the last few years.

      The problem is, if/when property prices come down, their LVRs could be pushing 90 or even 100%. In this scenario, you definitely don’t want all your loans with one bank. The more they know your business, the more pain they can bring you.

      What if they drop your LVR requirement back down to 80%? You’ve got to cough up some serious cash. This happened in the GFC to a mate of mine who is a builder. Although this is more likely to happen on the business banking side, it could still happen to investors with residential loans.

      I think it’s very risky to continue refinancing, especially interest only loans, up to the 80% max with every growth in property values. Of course, if property prices continue to only rise and never fall, no problem.

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