What is Hypothecation?

Anyone who has taken out an auto loan or mortgage has likely entered into a hypothecation agreement to secure the loan. Hypothecation is common with secured loans.

In the case of getting a mortgage on a home, without hypothecation, a borrower could default on the mortgage and yet still be able to keep the house. No financial institution would be willing to lend with such risk, leaving most people unable to buy a home without the cash to do so. Hypothecation makes lending and borrowing possible.

For borrowers who are unsure precisely what hypothecation is, here is a look at what this term means and why it benefits both borrowers and lenders.

What Is Hypothecation?

Hypothecation is the pledging of an asset as collateral for purposes of securing a loan. The borrower does not pass asset ownership rights to the lender, but if the borrower does not make their loan payments as outlined in the loan terms, the lender can take possession of the asset to recover their loss.

For a home or auto loan, this can mean foreclosure or repossession for the borrower. With most mortgages and auto loans, hypothecation is a standard requirement.

Hypothecation is only used with secured loans, such as secured personal loans and mortgages. Often with these types of loans, the asset being pledged as collateral has nothing to do with the reason for the loan other than to secure it. For instance, a borrower may pledge jewelry, a vehicle, or even stocks or bonds as collateral for a secured personal loan.

Hypothecation is also used in investing when investors buy on margin or short stocks. Short selling involves borrowing securities and requires the investor to open a margin account to pledge as collateral. Buying on margin involves borrowing money from a broker or bank to buy securities. The investor typically pledges securities or other investments as collateral.

How Does Hypothecation Work?

Here is a closer look at how hypothecation works for securing a mortgage or auto loan and investing.

Hypothecation for Mortgages and Auto Loans

When borrowers enter into a loan contract, they agree to pay back the loan as outlined in the loan contract. However, a bank or lender will not risk lending thousands of dollars without one of two things: collateral valued high enough to cover the loan or an extremely high interest rate. Lenders need a way to recoup their loss if a borrower defaults.

The borrower hypothecates the house or vehicle in exchange for a lower rate loan. If the borrower continues to make on-time payments, they can live in the home or drive the car used to secure the loan.

However, if the borrower defaults on the loan, the creditor has the right per the loan contract to foreclose on the hypothecated property or repossess the hypothecated car. The lender can then sell the house or car to recoup the money the borrower did not repay.

Hypothecation for Investing

Hypothecation works much the same with investing.

A broker will not lend money to an investor to buy on margin without some guarantee that it can get its money back if a margin call occurs and the investor experiences a loss. Thus, an investor can pledge other securities they own as collateral.

The investor gets to keep any gains on the securities bought on margin, but in case of a loss, the broker can take possession of the pledged securities and sell them to recoup the loss.

Why Should Borrowers Care About Hypothecation?

Hypothecation is an essential lending tool and probably makes lending possible by eliminating most of the risk to lenders. Because the lender can use the collateral to recoup a loss that may result from the borrower defaulting, it is not only willing to lend money but can do so at an affordable rate. This is why secured loans may have much better rates and terms than unsecured loans.

This, of course, is important to borrowers because it often means the ability for a borrower to get loan approval for a high-value asset at an affordable rate.

However, the borrower must understand that missed payments or loan default will result in the lender seizing the hypothecated asset.

Takeaway

Hypothecation is the pledging of collateral to secure a loan, and it can be a double-edged sword for borrowers.

By pledging collateral, the borrower can typically get reasonable loan rates and terms that enable them to possess and use a house, vehicle or some other high-value asset while paying off the loan. However, this also allows the lender to seize the item if the borrower defaults.

When entering into a loan agreement, it’s crucial for borrowers to understand all loan terms and whether hypothecation is applicable. This is true when taking out any secured loan or investor borrowing for margin trading and short selling with a brokerage account.

FAQ

Here are answers to common hypothecation questions.

• What is an example of hypothecation?

  • An example of hypothecation is the purchase of a car. When a borrower gets a car loan, the new car is typically used as collateral to secure the loan.

  • The borrower gets to possess and use the car as long as they make payments per the loan agreement. If the borrower stops making payments, the lender can repossess the car to sell it to recoup the outstanding balance on the loan.

• What are pledges and hypothecation?

  • To pledge an asset is to provide it as collateral to secure a loan. The actual pledging of the asset is called hypothecation. The pledged asset remains in possession of the borrower, but the lender may claim ownership if the borrower defaults on the loan.

• What is the difference between collateral and hypothecation?

  • Collateral is something with significant value that a borrower pledges to a lender to secure a loan. The act of pledging the collateral is called hypothecation.

• What is a letter of hypothecation?

  • A letter of hypothecation is a general term for a written agreement that authorizes a lender to take possession of an item pledged as collateral to secure a loan if the borrower defaults.

  • The name of this document will vary by industry and loan type. The term is most often used in international trade. The financial industry may use other terms for this document, such as hypothecation agreement or deed of hypothecation.

This article originally appeared on GOBankingRates.com: What is Hypothecation?