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The world of borrowing and investing money includes lots of terms you’ve probably never heard before. As you explore loan options and consider signing contracts, you might come across “hypothecation,” an important concept when obtaining a secured loan.
So, what is hypothecation? Let’s explore its meaning and how hypothecation impacts you.
- Hypothecation means offering an asset of value (collateral) as backing a loan. If you default on the loan, the lender can take the asset to recoup their money.
- The most common use cases for hypothecation include mortgages to buy residential and commercial real estate or loans to purchase vehicles.
- It's crucial to prioritize payments on any loans that involve hypothecation to prevent repossession of your property.
- If you ever find yourself in a position where you can't make payments on a hypothecated loan, it's important to contact the lender to avoid losing your asset.
What is hypothecation?
Hypothecation refers to the process of using an asset as collateral for a loan. With hypothecation, you agree to let that asset be used to secure the loan. But it only provides backing: You don’t sign any ownership rights over to the lender. You maintain full possession and use of the asset. The lender 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.
In short, hypothecation is the way the lender protects itself if the borrower doesn’t repay the loan or violates the loan agreement.
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 lending. 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, either, since these lines of credit aren’t secured.
Hypothecation in mortgages
Hypothecation is a common feature of home loans. When you buy your home using a mortgage — instead of paying cash — your home serves as collateral for the debt. Even though you’re buying the home, your lender is the one loaning you the cash for the transaction. 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
The hypothecation concept can also apply to investing.
Here, it’s a little different than it is in mortgages and other types of lending. If you’re buying on margin or selling short, the broker you’re dealing with gets hypothecations when you acknowledge that your investments can be sold if there’s a margin call. A margin call happens when you borrow money from a broker to invest in securities, and the value of those securities falls below a certain required amount. When your margin account dwindles below the minimum, you agree to sell those securities — or let the broker sell them — in order to make up the difference.
In other words, when you borrow from a broker for a short sale or buying on margin, they hypothecate (secure) the funds they lend you with the agreement to sell if the account drops below their limit. The securities are acting as collateral for the margin funds.
Hypothecation in other loans
While mortgages are one of the most common places you’ll see hypothecation, it can apply with other types of loans as well. To further build your hypothecation definition, let’s look at a couple more examples:
- 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.
Example of a hypothecation agreement
Hypothecation comes into play when you close on a home.
Let’s say you’re borrowing $400,000 with a 30-year mortgage. The agreement will include the payment terms with a call-out that if you fail to meet the terms of the loan (namely, making on-time payments every month), the lender can take possession of the home.
What’s the difference between assignment and hypothecation?
In the mortgage world, assignment is a lot like hypothecation. The big difference is that hypothecation happens when you take out a home loan. Assignment happens if the lending institution servicing your loan sells your mortgage note
to another institution (this is fairly common).
In this case, assignment means that the security instrument for your loan — in this case, your home — gets transferred to the new institution servicing your loan.
Why does hypothecation matter?
Hypothecation matters because it’s your formal 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: Several consecutive missed mortgage payments can give rights to the lender to foreclose on the home, leaving you with no place to live.
It’s essential to recognize the instances in which your property can get seized. If you’re ever in a financial bind and can’t make payments on all your bills, consider prioritizing them by which ones are hypothecated. For instance, you might want to make home and car payments before credit card payments so you don’t lose those 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.
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.
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 can take possession of the property if you don’t make your payments.
Liens are tied to hypothecation. If you’re still paying back your mortgage, your lender still 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 (i.e., is proof of hypothecation). With a mortgage, you agree to the lien. However, you can also have liens placed against your property due to failure to make other payments, such as property taxes.
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.