Collateral, also called security, consists of assets offered by a borrower in order to obtain a loan. In the event of failure to repay the debt, the collateral is confiscated in lieu of the outstanding amount. Any item of economic value, especially which could be liquidated or converted to cash can be pledged as collateral.
When collateral for one loan serves as collateral for other loans as well, it is called cross collaterization. The most common example being the case when a person wants to buy a new residence when he already owns one house. The property being cross-collateralized needs to be appraised and indemnified.
How one property can serve as collateral to different loans? The reason is “Loan to Value,” or LTV. This is the relative amount of the sum loaned against a property with respect to its value. As for example, a house that is at present priced at $600,000 with $300,000 debt has an LTV of 50%. That is, the owner has borrowed an amount which is 50% of the cost of the property. Some or the entire remaining price can be utilized as collateral for a different mortgage or credit. Cross-collateralization can be used to counterbalance risk factors involved in a financial transaction, that is, to allow the lender to circumvent the possibility of incurring a loss in case of default.
It is mandatory that the location of the property being cross-collateralized be in the same state as the new property being acquired. Cross-collaterization is offered on portfolio loans like the Option ARMs and the Flex 3 and Flex 5 loans, in which initially the rate of interest and the amount to be paid remain fixed for 3 years and 5 years respectively.
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