Cross Collateralization: What Is It and How Does It Work?

In debt financing, a lender issues money for an investment opportunity, such as a house or a business. The debtor agrees to pay back that money plus any interest accrued on the loan. However, in case the borrower doesn’t keep up their end of the agreement, the creditor usually requires an asset, or collateral, as a form of security to minimize their risk.

In most cases, the lender will use the borrower’s intended purchase as collateral, such as a house or a car, to secure the loan. However, sometimes a lender will ask for another form of collateral unrelated to the borrower’s current investment. This practice is known as cross collateralization.

Cross collateralization, also known as a cross-collateral loan, is the practice of using collateral from an initial loan to secure another loan from the same lender. For instance, when you buy a house, that house is used as collateral until you pay off your mortgage. Now let’s say you want to start a business from scratch. The business itself has no assets to offer as collateral, so in order to secure a business loan, the lender might use your house as collateral or offer you a second mortgage instead.

In this example, you are using an asset from an existing loan to secure another loan for a different investment. This can be a good way to finance multiple loans using fewer assets. However, it’s important to be aware of how many loans you’ve received from a single lender and exactly what assets they’re using for cross collateral, otherwise, you could end up losing assets you didn’t even realize were available for taking.

There are many different types of loans, but ultimately, they all fall into one of two categories: secured loans and unsecured loans. To understand how cross collateralization works, it’s worth first understanding what constitutes each type of loan.

An unsecured loan is a loan that is issued without collateral. For example, if a friend lends you money and you simply promise to pay them back later, that would be an unsecured personal loan (years of friendship and trust don’t count as collateral).

Payday loans and credit cards are examples of uncollateralized loans. Should you fail to pay off your loan or credit card bill, the creditor won’t be able to take any assets from you to cover the loss. To compensate for this, unsecured loans typically come with higher interest rates. This is why a credit card interest rate tends to be significantly higher than a mortgage interest rate.

A secured loan is a loan that is secured by some type of collateral. If you obtain a loan from a bank or other financial institution, that lender will typically ask for some type of collateral to secure the loan. The most common example of a secured loan is a mortgage, which uses your house as collateral. The bank places a lien on the property until the mortgage is paid in full. Because a secured loan is collateralized, lenders are more likely to offer a low interest rate.

Cross collateralization offers borrowers a way to leverage their existing assets for an additional loan. Because this second loan doesn’t have to be related to the first, a cross-collateral loan can be used for a wide variety of purchases. Here are some of the most common examples of cross-collateralized loans:

A second mortgage is when you take out another loan on top of your existing mortgage but still use your house as collateral. In many cases, homeowners who take out a second mortgage wait until the value of their home is significantly higher than what they paid for it. This way, they have more equity in their home to draw from.

A second mortgage could be used to pay for school, start a business, or cover an emergency expense. In any case, the house will serve as collateral for both the initial home loan and the second loan taken out for a separate purpose.

Developing your own property can be a daunting task, especially when it comes to getting a construction mortgage. There is no home on the land to use as an asset, so the value is in the land itself. However, because a bank cannot loan you a significant amount based only on land value, they will typically use some sort of cross collateral instead. This could be your car, an additional property, or shares in a company.

Many business loans, particularly for startups, will use cross collateralization if the business does not have significant assets or is in too much debt. If you are opening a food truck, for instance, the bank might ask for a more valuable asset to use as collateral, such as your house or your car.

A credit union is a not-for-profit alternative to a bank that loans money at a community level. Because their interest rates are more affordable, credit unions are not typically flush with cash, so they usually require collateral to secure the loans they offer.

Cross collateralization is a fairly common practice among credit unions. Even for normally unsecured debt, like a credit card, a credit union will usually use cross collateralization to minimize their risk, so make sure you understand the terms before agreeing to the loan payments.

One particularly prominent example of cross collateralization is the case of Elon Musk’s proposed takeover of Twitter in early 2022. At the time of his announcement, Musk was famously worth over $200 billion, but much of his net worth was tied up in Tesla and SpaceX stock.

Musk initially offered to buy Twitter for $44 billion and take the company private. In order to finance the buyout, he would have to take out loans against his stock in Tesla. This is an example of cross collateralization at its finest, as Musk would be using the asset of his Tesla stock as collateral to secure his purchase of a separate company.

It’s worth noting here that Elon Musk’s case is an exception. Tesla is a publically traded company with liquid stock, and Musk’s net worth and enormous stake in the company make issuing loans to him less of a risk to lenders. While stocks can be used as collateral for a loan — a practice known as security-based lending — banks typically won’t offer this option to borrowers with small portfolios; you would need a significant share in a company to use as an asset.

Whenever you sign a loan agreement, it’s important to read the contract carefully. Some lenders will use a sneaky form of cross collateralization known as a “dragnet clause,” which gives them access to assets other than the one initially used to secure the loan. To give one example, if you were to default on credit card debt, a dragnet clause would allow the creditor to take your car as collateral.

Cross collateralization works by using collateral for an existing loan to secure a second loan unrelated to that asset. If you use the car from your auto loan as collateral to secure a loan for your business, that’s an example of cross collateralization.

A cross-collateralization clause, also referred to as a dragnet clause, is a clause in a loan contract that gives a lender access to assets other than the one initially used as collateral. The lender can then seize these assets if you fail to pay off your initial loan.

In the music industry, cross collateralization is a clause in recording and publishing contracts that allows companies to recover advances issued for one album by collecting revenue from future releases.

To collateralize something is to use it as an asset to secure a loan. The lender then has a right to take that asset if the borrower defaults on the loan.