Hypothecation

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What You Should Know

  • Hypothecation occurs when a borrower pledges an asset as collateral to secure a loan.
  • When an asset is pledged as collateral, the owner retains the ownership title and any income generated by the asset.
  • If a borrower defaults on a loan that is secured by an asset, the lender would have the right to seize the asset.
  • Hypothecation may be useful to a borrower who would want to have a lower interest rate or has a bad credit history.

What is a Hypothecation?

Hypothecation

Hypothecation is when an owner of an asset agrees to use it as a collateral to secure a loan. Secured loans such as car loans and mortgages require collateral, so a borrower who would like to get a secured loan may pledge their property as collateral. An asset that is used as a collateral for a loan is still controlled by the owner. This means that the owner does not give up ownership rights or title or any income generated by the collateral to the bank. On the other hand, if the borrower defaults on the loan that is secured by the collateral, the lender has a legal right to seize the collateral.

Hypothecation may be useful to borrowers for various reasons. Even though borrowers risk losing their assets that they use as collateral, hypothecation may reduce interest rates and fees associated with a mortgage. Additionally, investors who try to get a mortgage with bad credit may have a higher chance to get approved if they pledge more collateral. Lenders estimate interest rate on a mortgage based on the riskiness of the mortgage. The riskiness of the mortgage includes various factors such as the borrower's profile, debt-to-income ratio, loan-to-value ratio and others. By pledging more assets as collateral, a borrower may lower the riskiness of their debt because in the event of default, the lender would be able to recover a larger amount from the collateral.

Pros and Cons of Hypothecation
ProsCons
A borrower is more likely to get approved for a loan.In the event of default, a lender has a legal right to seize collateral.
A borrower keeps ownership title to the asset pledged as collateral.
A borrower may get a lower interest rate in a secured loan.

An example of hypothecation is a rental property that is being pledged as collateral against another mortgage. If an owner of a rental property wants to purchase another property, they may use their existing property as collateral to get approved for a mortgage. In this case, the owner of the rental property does not lose any rights to the property that is used as collateral. They still hold the ownership title for the property, and they get to keep the rental income generated by the property. On the other hand, if the owner fails to meet their debt obligations, the property will move into a pre-foreclosure stage where the owner may try to renegotiate the debt agreement or give up the property.

Where Does Hypothecation Occur?

Hypothecation is not a common practice in every type of lending. For example, personal loans are usually unsecured, so they do not require hypothecation. On the other hand, there are quite a few types of lending where this term is used often.

Residential Real Estate

The most common type of lending that uses hypothecation is mortgage lending. It is unlikely that a borrower can get a mortgage without securing it with collateral. Usually, the property that is being bought on a mortgage is being used as collateral, but if a borrower already owns another property, they may hypothecate their property to get a mortgage. Borrowers who use their property as collateral for a mortgage still hold the ownership title of the property and are entitled to any income the property earns. On the other hand, if the borrower defaults on the mortgage, the lender has a legal right to seize the property through a foreclosure process.

Commercial Real Estate

Just like with mortgages for residential properties, the same principles apply to commercial real estate. An investor may get a mortgage from a lender to purchase a commercial property, but they will have to use another property as collateral. It does not have to be another commercial property. Most lenders require a borrower to hypothecate their home or any other investment property they have. In some cases, lenders may require to put down multiple pieces of collateral to cover the value of the mortgage. Commercial real estate may be more expensive than residential houses, so the lenders tend to ask for larger collateral to ensure that the loan is well-secured.

Stock Market

Hypothecation also is widely used in stock market investing. It occurs when an investor purchases or short-sells the stocks on margin. This means that an investor takes a loan from a lender, and uses the money to buy or short-sell stocks. These securities that are traded, are used as collateral. In this case, if the value of securities falls below a certain value, the lender has the right to ask for additional funds to fulfill margin requirements or to sell the collateral to cover the outstanding debt of the borrower. This process is also known as a margin call.

Other Loans

Hypothecation happens in other types of loans that require to be secured. Auto loans usually take a car or other vehicle as collateral for the loan. If a person defaults on their auto loan, then the lender can seize the vehicle and sell it to recover the debt outstanding. Home equity loans are loans that require property as collateral just like with mortgages. The last are business loans that also require hypothecation in some form of collateral. Usually, business loans are flexible on the type of assets they may accept.

Rehypothecation

Rehypothecation occurs when a lender uses the collateral in a loan as collateral for another loan. If a lender needs to meet certain collateral requirements for a loan, they may use the collateral pledged for the issued loans to meet the requirements. This practice was widely used before the financial crisis of 2008, but currently, rehypothecation is a rare practice. Because rehypothecation allows single collateral to be hypothecated multiple times, it becomes unclear who is the end owner of the collateral, which may invalidate the clear title of ownership of the property.

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