What is hypothecation?

Hypothecation is the promise of collateral in return for a loan. When a lender chooses to issue a loan to a borrower, the lender sometimes requires collateral to secure the loan in case of default. When that happens, the borrower’s asset is hypothecated, or collateralized.

Deeper definition

Hypothecation provides security for a lender by compelling the borrower to put up collateral to protect the lender from losses if the borrower defaults. If the borrower falls behind on her payments, the lender can possess the asset. Such hypothecated loans include both mortgages and financing other expensive goods.

Hypothecation is also a feature of loans in finance, especially with repurchase agreements, in which a security is purchased with loaned money and resold at a later date.

Collateral can be rehypothecated, too. That happens when the lender uses an asset owned by a borrower as its own collateral for the purpose of trading.

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Hypothecation example

On a loan of $100,000, the interest rate could be as high as 15 percent (or up to $15,000) if the loan is unsecured by collateral. However, if the practice of hypothecation applies and an asset is put up as security, the interest rate could be lower, such as 5 percent (or $5,000), depending on the terms provided by the lending company.

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