Hypothecation Definition

What is Hypothecation?

Hypothecation is the action of putting up property or other assets as collateral for a loan, while still owning the property or assets and maintaining full use and possession of the property. When a borrower allows their lender to put a lien on their real estate, or a financing lien on an asset they've purchased (e.g. - car, boat, equipment, inventory, or otherwise), the assets have been "hypothecated" or designated as collateral.

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Hypothecation Explained

Hypothecation is the action of:

Putting up property or other assets as collateral for a loan, while still owning the property or assets and maintaining full use and possession of the property.

When a borrower allows their lender to put a lien on their car, or a financing lien on an asset they’ve purchased (e.g. – boat, equipment, inventory, or otherwise), the assets have been hypothecated or used as collateral.

Hypothecation applies to movable assets, and not to unmovable assets like real estate, house, or improvements. Hypothecation means that the borrower owns and possesses the movable assets, and can use and enjoy the assets until and unless there is a default on the loan.

The Purpose of Hypothecation

Hypothecation serves as a type of guarantee that the lender’s funds can be fully recovered in some way, shape or form. Even if the borrower fails to return all of the borrowed money in the form of payments, the lender will have the fallback option of recouping their money by taking possession of the hypothecated assets in the event of a default.

loan collateral

Since hypothecated assets give lenders this kind of added assurance, hypothecation can also serve borrowers by allowing them to obtain a better interest rate on their loan, since it arguably minimizes their credit risk in the eyes of the lender.

Hypothecation vs. Pledged Assets

Hypothecation of collateral allows the borrower/buyer to possess and use the assets that are hypothecated while they are still paying for them. The title of the asset remains in the name of the borrower during the life of the loan. Another type of collateralization, known as a pledge of collateral, is similar to hypothecation except that the lender takes possession of the pledged collateral.

In a lending transaction, a borrower may choose to pledge additional assets (e.g. – stocks, bonds, securities, certificates of deposit, cash or other liquid assets) to their lender. In this situation, the lender may take possession of the stocks, bonds, securities, certificates of deposit (CD), or cash accounts.

When a borrower chooses (or is required by their lender) to pledge assets, the borrower is still the owner of the assets pledged and the borrower may continue to earn interest, dividends, or other cash flow from the pledged assets. However, the lender has possession and has the additional right to take ownership of these assets in the event of default.

A pledge of collateral may be used as a way of reducing or eliminating the lender’s requirement for a down payment. A pledge of assets can also be volunteered by the borrower as a way to justify a lower interest rate or to eliminate the need for additional PMI with their monthly payment.

For instance, suppose a real estate investor is buying a house for $100,000. In order to avoid the additional cost of Private Mortgage Insurance (PMI) with their monthly payment, the bank requires a $20,000 (20%) down payment. If the borrower only has $10,000 of cash but they’re also willing to pledge an additional $10,000 of stocks.  The bank may be willing to take and hold this additional collateral and in exchange, release the requirement for a full 20% down.

Hypothecation vs. Mortgage

When a borrower allows their lender to put a mortgage on their home or a financing lien on the real estate they’ve purchased, the home has been mortgaged or subjected to a deed of trust.  The difference between hypothecation and a mortgage is that hypothecation refers to movable assets, and mortgage refers to unmovable assets. For example, vacant land, a building, a house, fixtures, and improvements, are all considered unmovable assets that would be “mortgaged” rather than “hypothecated.”

mortgage image

A common example of a mortgage or deed of trust is when a home buyer is acquiring real estate and voluntarily allows their lender to put a lien on the real estate they are purchasing. The home buyer is listed as the owner of record, and the homebuyer can use and occupy the property.  However, the lender has the right to foreclose, take possession and sell the property if the borrower defaults on their loan. But as long as they continue to make the payments, they will retain full possession, title, and use of the property.

Hypothecation Vs. Unsecured Loan

Hypothecation generally makes it easier for a borrower to obtain a loan because the hypothecated asset provides an additional layer of protection for the lender in the event of a default (assuming the borrower also has a decent credit score and debt-to-income ratio, along with the other 5 Cs of Credit). If the borrower stops paying, the lender has a better chance to make themselves whole since it has possession of the borrower’s hypothecated asset(s).

An unsecured loan is typically more difficult for a loan applicant to get because the lender doesn’t have any guarantees of repayment outside of the borrower’s creditworthiness. In the event that a lender will approve an unsecured loan, the interest rates will usually be higher, and/or the payback terms will be more restrictive since the lender can rely only on the borrower’s creditworthiness.

Perhaps the most common type of unsecured loan is a credit card, which typically has a much lower credit limit, has a significantly higher interest rate, and will have a much shorter repayment timespan.

Reviewed by Mark H. Zietlow, Innovative Law Group

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