Cross collateralization is a clause in a purchase contract that secures a loan which serves as collateral for all other loans made with the borrower in the past, present, and future. This type of loan is usually found at credit unions, but can sometimes be found at your typical banks.

Cross collateralization most commonly occurs with car loans. When you buy a vehicle from a bank or credit union you usually sign a security agreement that secures your car to the loan. This results in the lender holding the title to your car until you pay off the loan. If you default on the loan the bank or credit union can repossess your car. Most people are aware of this kind of agreement.

However there may also be a clause in the vehicle loan that ties any unsecured loans to that vehicle too. So if you later open a line of credit, a credit card account, or take out a personal loan from the same lender, those normally unsecured debts now become secured to your vehicle. If you decide to pay off your car loan to take possession of your car title, the credit union or other lending institution may not let you have the title until all your loans owed to them are satisfied. That means you could be paying much more for your car than you owe and probably more than it’s worth.

This dilemma becomes particularly sticky in bankruptcy, especially if the debtor is trying to file a Chapter 7 bankruptcy. In a Chapter 7 bankruptcy you either have to surrender your vehicle or reaffirm the debt. If you reaffirm the debt and your loan is with a credit union that has secured all other debts to your car you will have to pay those debts back too before you can keep you car. Normally those other debts would have been wiped out as unsecured debt in a Chapter 7. Most people who file bankruptcy don’t have the extra cash to pay of all of their debts.

One solution would be to file a Chapter 13 bankruptcy and repay your debts over a three to five year period. In a Chapter 13 bankruptcy the debtor can use the “cramdown” provision of the bankruptcy code. That allows you to pay the full amount of the value of the car and not all the other debts owed to the lender. The remaining debt is treated as unsecured debt and is discharged in bankruptcy.

Another cross collateralization trap can occur when a debtor has a loan and a checking account at the same lending institution. If he or she becomes past due on the loan the lender may access his or her checking account to pay the loan or freeze the account until it becomes current.