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. Here’s what it means.
- Hypothecation involves offering an asset of value (collateral) in exchange for 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.
- Hypothecation also plays a role in investing if you’re buying on margin or selling short.
- 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, it’s important to contact the lender to avoid losing your asset.
What is hypothecation?
Hypothecation is the process of agreeing to use an asset as collateral in exchange for a loan.
With a car loan, for example, you agree that your car is used as collateral to secure your loan; if you can’t repay the loan, your lender can repossess the car.
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 hypothecation only affects secured loans.
Hypothecation in mortgages
Hypothecation is commonly found with home loans. When you buy your home using a mortgage — instead of all cash — your home serves as collateral. Even though you’re buying the home, your lender is the one loaning you the cash for the transaction. If you don’t hold up your end of the contract, your lender could take your home.
Additionally, hypothecation plays a role in second mortgages like home equity loans and lines of credit (HELOCs): 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 real estate
It’s also quite common to see hypothecation in commercial real estate. When you’re investing in a commercial property, your lender might ask you to put your home or another investment 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
Hypothecation in investing is a little different than it is in mortgages and other types of lending. If you’re buying on margin or sell short, you acknowledge that those securities can be sold if there’s a margin call. A margin call is when you borrow money from a broker to make an investment and the account falls below the required amount. When your margin account falls short, you agree to sell those securities.
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.
- 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 business, you could agree to use that equipment as collateral for your loan.
Example hypothecation agreement
When you close on a home, the closing documents spell out the most common example of hypothecation. Let’s say you’re borrowing $200,000 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.
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. Several consecutive missed mortgage payments can lead to a home foreclosure, 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.
“name”: “What is rehypothecation?”,
“text”: “Rehypothecation is when a lender uses your collateral as collateral 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 2008 Great Recession. Because the collateral continues to get rehypothecated, it becomes less clear who really owns the asset.”
“name”: “What is hypothecation vs. assignment?”,
“text”: “When you initially enter into a mortgage contract, 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 be assigned to a different servicer. 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.”
“name”: “What is hypothecation vs. lien?”,
“text”: “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. 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.”
Any time you borrow money to make a purchase — whether a home or an investment — there are risks involved. Using assets and property to take out a loan 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 payment 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.