Key takeaways

  • Hypothecation means offering an asset as collateral, or as backing for a loan.If you default on the loan, the lender can take the asset to recoup their money.
  • Common uses for hypothecation include real estate mortgages, auto loans and investment margin accounts.
  • It's crucial to prioritize payments on any hypothecated loans and, if you can't make payments, to contact the lender to avoid losing your asset.

The home buying and financing world 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.

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, or back 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 financing: 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.

What are the benefits of hypothecation?

Although hypothecation requires you to pledge an asset in return for a loan, it does have its uses. Some of the advantages of hypothecation include:

  • Ease of obtaining financing: Hypothecation reduces a lender’s risk, making the institution more likely to offer financing. Loans for large amounts, like six-figure mortgages, probably wouldn’t be feasible without hypothecation.
  • Cheaper loans: Interest rates on hypothecated loans tend to be lower than those on unsecured loans. Since the lender has collateral for the loan — and a chance to recoup its money if you default — it can make the cost of borrowing cheaper.
  • Ownership/possession of the asset: The borrower keeps ownership of the asset; no title change or transfer is required.

What are the disadvantages of hypothecation?

Some of the downsides of hypothecation include:

  • Asset at risk: Yes, you still own and control the asset — but hypothecation gives the lender a claim to it. If you are not able to pay your loan back or if you do not meet its terms and conditions, the lender has the right to seize your asset and sell it.
  • Finances at risk: Under hypothecation, you may face legal action if the lender cannot fully recover its funds even after taking your asset.
  • More interest paid: Hypothecated loans often have longer terms. So while the interest rate may be lower, you’ll be paying more in interest overall. And of course, your total cost for the asset will be more than if you had paid cash for it.

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, your broker 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 loaned money.

Hypothecation in other loans

While mortgages and home equity loans are the most common places you’ll see hypothecation, it can apply with other types of loans as well, like:

  • 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.

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.

Hypothecation FAQ

  • 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.
  • A lien is a claim on a property, and means that property can’t be sold or refinanced, and its title transferred, until that claim is settled. Liens are often tied to hypothecation. If you’re still paying back your mortgage, your lender 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 unrelated to hypothecation: nonpayment of taxes, such as property taxes, or outstanding debts.
  • Both pledged assets and hypothecation refer to securing a loan — using something as collateral for it. But under hypothecation, you retain possession of your asset. Pledging involves physically transferring the asset to the lender.

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.