Cross Collateralized and Cross Defaulted on Business Loans
Posted by Bill McDermott on Mon, May 02, 2011 @ 08:15 AM
These two terms are used widely by bankers and agreed to by business owners. However, it's important to you, the business owner to understand what the implications of these terms are when triggered. Let's talk about what it means to have your business loans cross collateralized and cross defaulted.
Let's pretend you have a line of credit secured by accounts receivable and inventory. (Loan A) You also have a mortgage loan with your company building as collateral. (Loan B). Both loans are with the same bank. If your loans are cross collateralized that means the collateral for Loan A and B are identical. Accounts receivable and inventory are collateral for the line of credit and the mortgage. Also, your company building is collateral for the mortgage, as well as, the line of credit. If you ever tried to move either loan from your bank separately, you couldn't unless the bank would allow it. You might be forced to move them together which may be unattractive because of rate, closing costs or prepayment penalties.
If your loans have a cross default provision, that means a default on loan A triggers a default on Loan B and vice versa. You may be making prompt payments on either loan or both loans, but if you default on one, it's as if you default on both.
I'm providing financial consulting services help to a client right now who broke the cash flow covenant in his mortgage last year. That covenant triggered a default on his mortgage and his line of credit because both loans were cross defaulted. My client has a commitment to move his line of credit away from this lender to get a larger line at a better rate. However, we have to get the bank's permission to do that because both loans are cross collateralized. If the current bank does not release the collateral on the mortgage, we may be forced to either stay with the current bank or payoff both loans. Neither alternative is attractive to my client.