Did you know that it’s possible for your car to be used as collateral for a debt other than an auto loan?
A lot of borrowers have been surprised by lenders, particularly credit unions, who use this practice to reduce lending risk. These borrowers didn’t know that some lenders can do something like that when they apply for another loan with them.
The practice is called cross-collateralization. And borrowers are not often informed about this practice and its terms.
How Does Cross-Collateralization Happen?
Plainly speaking, cross-collateralization is the practice of securing more than one loan with the same asset. Lenders do this to reduce financing risk and to force people with really poor credit standing to honor their debts.
To illustrate: George took out a car loan from Credit Union Q. (Keep in mind that a car loan is a secured loan for which the car to be financed serves as the collateral.) The car loan agreement contains a cross-collateralization clause.
After a few years, George approached Credit Union Q for a home loan. He was able to complete his payments on the car loan by this time and wants to sell the car. But Credit Union Q vetoes George’s decision because his car is still being used as collateral for his home loan. That’s what the cross-collateralization clause in the car loan agreement was for.
Cross-collateralization can also happen with unsecured loans like credit cards. To further reduce risk, some lenders use a borrower’s asset as collateral for his or her credit card debt, which is supposed to be unsecured. In our example, this means that the credit union can also use George’s car as collateral if George opens a credit account with them.
The Problem With Cross-Collateralized Auto Loans
From our example above, we can draw specific problems that a cross-collateralization clause in a loan agreement brings:
- The clause is often hidden as fine print and not discussed with the borrower. Some lenders, however, inform their borrowers about the practice. But borrowers can forget over time, especially if they go through a difficult financial situation.
- Borrowers are not often informed beforehand that the terms of the cross-collateralization clause will be effective in their second loan.
- You might not be able to sell your car if it is still being used as collateral for another loan.
- Your lender has the right to repossess your vehicle in the event you failed to make payments on either loan you have with them.
How to Avoid
To best protect yourselves, here are some practical ways by which you can avoid suffering the consequences of a cross-collateralized auto loan:
- Avoid having more than one loan from any single financial institution. Always shop around for the best offer when you take out a loan.
- Cross-collateralization is common among credit unions, but it is also a practice of some banks. Choose your lender carefully then. Make sure the company is reliable and trustworthy. You can ask around for recommendations.
- It is extremely important that you read the loan agreement thoroughly before signing on the dotted line. If you don’t understand the terms, consult with a lawyer. Do not also hesitate to clarify with your lender any vague clause in the paperwork.
It is important to remember that cross-collateralization is often hidden deep in fine print. Do not be ignorant and scrutinize all the terms indicated in the agreement. You can always seek expert advice if you aren’t too sure about the terms.
Make sure that you don’t accidentally sign up for more than you are willing to handle. Cross-collateralization can be ruinous for your credit rating and finances.