What Is Collateral?
When a bank loans a large sum of money, they need a guarantee that they will get their money back even if the borrower stops making payments. Collateral is the asset that serves as that guarantee. By pledging an asset as collateral, the borrower reduces the lender's financial risk, which is why collateralized loans (like mortgages and auto loans) offer significantly lower interest rates than unsecured loans (like credit cards).
Real Estate as Collateral
Real estate is the most common and valuable form of collateral. In a standard home purchase, the borrower signs a promissory note agreeing to repay the debt, and signs a mortgage document that legally pledges the physical house and land as collateral.
If the borrower defaults on the promissory note, the mortgage document gives the lender the right to initiate a foreclosure lawsuit. The court will order the collateral (the house) to be sold at a public auction, and the proceeds will be given to the bank to satisfy the unpaid debt.
Cross-Collateralization in Commercial Real Estate
In commercial real estate development, investors often use cross-collateralization to fund new projects. If an investor owns a shopping plaza free and clear, they can use that plaza as collateral to secure a loan to build a brand new apartment complex.
While this allows the investor to access massive amounts of capital without putting cash down, it is extremely risky. Because the loans are cross-collateralized, if the new apartment complex fails and the investor defaults on the new loan, the bank has the legal right to foreclose on and seize the successful, fully-paid shopping plaza.
Related Terms
- Mortgage — The legal instrument that pledges real estate as collateral
- Chattel Mortgage — A loan that uses personal property (equipment/vehicles) as collateral
- Foreclosure — The legal process of seizing the collateral
Barnes Walker Commercial Financing
Barnes Walker's attorneys assist real estate developers and commercial investors in negotiating complex loan terms, ensuring that cross-collateralization clauses do not unnecessarily jeopardize the investor's core property portfolio. Request a legal inquiry for assistance.
Reviewed by the attorneys at Barnes Walker, Goethe, Shea & Robinson, PLLC