What is cross collateralization?
Credit unions, under federal law, have the right to cross collateralize debts if the borrower has agreed to cross collateral clauses in loan documents. In simple terms this means that the credit union can use the collateral for one loan to secure other loans that the credit union has made to that same individual. An example of this is if a person has a car loan with a credit union and they also have a personal loan from that same credit union; the loan documents for both the car loan and the personal loan provide that the collateral for the car loan (the car) is security for the personal loan as well. Credit unions loan agreements always provide that any loan (or credit card) through the credit union is also secured by the deposit accounts at that credit union. If the borrower remains current on all of these debts there is no problem, and the borrower likely has no idea that the credit union ties all of the loans together. However, if the borrower defaults on one debt, the credit union may take actions against the collateral. Typically the first thing the credit union will do if the borrower misses a payment is take the payment out of the borrower’s deposit accounts held at the credit union. They can do this because the deposit accounts are collateral for the loans held by that credit union. Once there are no longer any funds on deposit to pay for the payments on the loan, then the credit union will typically initiate collections calls or other collections actions. They may also send a notice to the borrower that the other collateral for the debt (in this example, the car) may be repossessed to pay for the debt.
How can the credit union do this?
Federal law allows credit unions to cross collateralize debts provided that the borrower consents to this by signing loan agreements for all of the affected debts which clearly state that the debts will be cross collateralized. The most common collateral to be held by the credit union are first the deposit accounts of the borrower, and second vehicles which are collateral for purchase-money loans of the borrower with that credit union.
Are there any exceptions?
Yes. First, it is only credit unions that can cross collateralize debt in this general way. Second, the credit union can NOT cross collateralize any debts with a mortgage loan unless the borrower specifically authorizes their real property to be collateral for a loan. Third, the credit union can NOT cross collateralize any debts with a qualified retirement account.
How does this work in bankruptcy?
The problem of cross collateralized debts is an issue that we look for in our initial meetings with prospective clients. We do this because multiple loans with a credit union can be a problem in bankruptcy, and we also do this because this problem in bankruptcy can often be avoided with advance planning. As noted previously, the two most common forms of cross collateral for a credit union are deposit accounts and vehicles. If a client who has multiple loans at a credit union files bankruptcy, the credit union will immediately freeze the client’s accounts at that credit union, preventing the client from accessing their money. The credit union will then apply the money in the bank account to the loans owed to the credit union. If the client has a vehicle loan with the credit union, the credit union will then require the client to reaffirm on both the vehicle loan and the other debts owed to the credit union in order to keep the vehicle. If the client doesn’t agree to pay all of these debts, the credit union will repossess the vehicle.
How can this be avoided?
When meeting with a prospective client who banks at a credit union and has loans with that credit union, the first piece of advice is to open new deposit accounts at a different institution, shift their banking to the new institution, and abandon the credit union. This moves the deposit accounts away from the credit union, preventing the credit union from taking the money in the prospective client’s accounts. If the potential client has a vehicle loan and other loans at the credit union, the potential client has several options: First, the potential client can pay off the vehicle before filing bankruptcy. Second, the potential client can refinance the vehicle with a different lender. Third, the potential client can trade the vehicle in on a different vehicle and finance it through a different lender. Fourth, the potential client can file a Chapter 13 to pay off just the vehicle loan (and not the other loans) to get clear title at the end of the Chapter 13.
If you have multiple debts owed to a credit union, do yourself a favor and contact us for an experienced attorney who can help you navigate cross collateralized debts.