What is hypothecation?

What is hypothecation?

Hypothecation refers to the process of using an asset as collateral for a loan. It is the way the lender protects itself if the borrower doesn’t repay or violates the loan agreement.

With hypothecation, you agree to let that asset be used to secure, or back, the loan. But nothing literally changes about the asset: You maintain full possession and use of it. The lender doesn’t receive any ownership rights or privileges. It has a right to the asset only if you default on the debt or fail to live up to the loan terms in some other major way.

Often, the asset in question is the thing you’re borrowing the money for. With an auto loan, for example, you agree that your car is used as collateral for the money to buy the car. You get possession of the car, but if you can’t repay the loan, your lender can repossess it.

Hypothecation isn’t part of every type of financing: It only applies to secured loans. For instance, you won’t see it with most personal loans since they’re usually unsecured. When you get a new credit card, there’s no  hypothecation, meaning these lines of credit aren’t secured and you don’t have to put anything up to back them.

Types of hypothecation agreements

Hypothecation comes into play with several different types of consumer financing.

Hypothecation in mortgages

Hypothecation is a common feature of mortgages. When you take out one of these loans to buy your home — instead of paying out-of-pocket for it — your home serves as collateral for the debt. Even though you’re going to be the homeowner, your lender is the one loaning you the cash to make the purchase happen. And they want recourse if you don’t repay them. As a result, the loan comes with hypothecation, meaning if you don’t hold up your end of the contract, your lender could take your home.

The hypothecation definition we’ve laid out usually applies to other sorts of home-related financing, too. Hypothecation plays a role in second mortgages like home equity lines of credit (HELOCs) or home equity loans. You’re borrowing money based on the equity you have in the property and agreeing to use the home as collateral to access the funds.

Hypothecation in commercial real estate

It’s also quite common to see hypothecation in commercial real estate. When you’re buying a commercial property, your lender might ask you to put your home or this property up as collateral.

Similarly, hypothecation can be involved in real estate loans for investment properties. In some cases, lenders might not give you a loan unless you put up several pieces of collateral, such as a rental property or a car, in addition to your primary residence.

Hypothecation in investing

Hypothecation works a bit differently in investing than it does with mortgages and other loans.

When you borrow from a broker to invest in securities, they hypothecate the funds they lend you: The securities are acting as collateral for the loaned money, in other words. While you do have to repay that loan eventually, that’s not the only thing that can put this asset at risk. Should the value of those securities fall below a certain required amount, you agree to sell the securities, or let the broker sell them, or to make up the difference with fresh funds, in order to pay part of the borrowed money back.This is known as a margin call.

Hypothecation in other loans

While mortgages and home equity loans are the most common places you’ll see hypothecation, it can apply with other types of loans as well, like:

• Auto loans: You agree to use your car, motorcycle, RV or other vehicle as collateral to secure your loan.
• Business loans: If you take out a loan to pay for equipment for your company, you could agree to use that equipment (or perhaps other corporate assets) as collateral for your loan.

Why does hypothecation matter?

Hypothecation is important. It’s part of your formal loan agreement: that if you fail to meet the conditions of the loan — such as making payments on your car or home — your property could get taken to cover those missed payments.

Knowing the definition of hypothecation particularly matters when you become a homeowner. Mortgages are a hypothecation loan. That means that several consecutive missed mortgage payments can give rights to the lender to foreclose on the home, leaving you with no place to live.

If you’re ever in a financial bind, consider prioritizing bills based on which ones are hypothecated. For instance, you might want to make home and car payments before credit card payments so you don’t lose some valuable assets. While failing to make credit card payments can ruin your credit score and possible lending opportunities in the future, there’s no hypothecation agreement to put anything up as collateral in these contracts.

What are the benefits of hypothecation?

Given the potentially dire consequences of pledging an asset, you might doubt there’s any upside to hypothecation. But actually, it does have its benefits. Some of the advantages of hypothecation include:

• Ease of obtaining financing: It reduces a lender’s risk, making the institution more likely to offer financing. Loans for large amounts, like six-figure mortgages, probably wouldn’t be feasible without hypothecation.
• Cheaper loans: Interest rates on hypothecated loans tend to be lower than those on unsecured loans. Since the lender has collateral for the loan — and a chance to recoup its money if you default — it can make the cost of borrowing cheaper. (However, hypothecated loans often have longer terms. So while the interest rate may be lower, you could be paying more in interest overall.)
• Ownership/possession of the asset: The borrower keeps ownership of the asset; there’s no title change or transfer.

Bottom line on hypothecation

Using assets to secure a loan through hypothecation has big consequences if you fail to make payments, or violate the terms in some other way. It’s essential to recognize the instances in which your property can get seized.

If you ever find yourself in a situation where you can’t make payments on a hypothecated loan, talk to your lender about alternative repayment options or modifications as soon as possible. Negotiating early alleviates the need to borrow extra money, like through a payday loan, which would only increase the financial strain.

Hypothecation FAQ

• What is rehypothecation?

  Rehypothecation is when a lender uses your collateral as collateral for obligations of its own. If your lender needs to meet certain contractual agreements, it might use your property to do so. While possible, this practice isn’t as common as it was before the Great Recession. Because the collateral continues to get rehypothecated, it becomes less clear who really has rights to the asset.

• Is hypothecation the same as assignment?

  No, though they both relate to collateral — the asset backing your loan. When you initially enter into a mortgage contract, with hypothecation, you’re telling the lender that originates your loan it can take back the property if you don’t make your payments. However, mortgages are bought and sold on the secondary market all the time, so your loan might become the possession of a different lender. While the assignment changes and you make payments to a different company, the terms of your loan remain the same. It simply means that a different company — the one with the current assignment — can take possession of the property if you don’t make your payments.

• What is hypothecation vs. lien?

  A lien is a claim on a property, and means that property can’t be sold or refinanced, and its title transferred, until that claim is settled. Liens are often tied to hypothecation. If you’re still paying back your mortgage, your lender has a lien on your property, which serves as evidence of its right to take over your home if you don’t make your payments. However, you can also have liens placed against your property unrelated to hypothecation, for things like nonpayment of property taxes or contractors’ services.

• Hypothecation vs. pledged assets: What’s the difference?

  Both pledged assets and hypothecation refer to securing a loan — using something as collateral for it. But under hypothecation, you retain possession of your asset. Pledging involves physically transferring the asset to the lender.

Bottom line on hypothecation

Any time you borrow money to make a purchase — whether a home or an investment — there are risks involved. Using assets and property to secure a loan through hypothecation has big consequences if you fail to make payments.

If you ever find yourself in a situation where you can’t make payments on a loan with collateral, talk to your lender about alternative repayment options or modifications as soon as possible. Negotiating early alleviates the need to borrow extra money, like through a payday loan, which would only increase the financial strain.