Hypothecation is when you agree to give a certain asset in exchange for a loan. Secured loans, like auto loans and mortgages, require collateral. If you end up defaulting on your loan, a lender can use that collateral to pay for the outstanding loan. When that happens, the asset is hypothecated.
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 pay back the loan, your lender can repossess the car.
Hypothecation isn’t in every type of lending. For instance, you won’t see it in most personal loans, since those are 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 used in home loans. When you buy your home using a mortgage — instead of all cash — your home is used as collateral. Hypothecation is when you agree to use your home as collateral and understand that if you can’t make payments on your mortgage, your home could be seized.
Even though you’re the owner of the home, with your name on the title and deed, not holding up your end of the contract means that your lender could take your home.
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 you 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’s in other types of loans as well.
- Auto loans: You’re agreeing to use your car, motorcycle, RV or another vehicle as collateral to secure your loan.
- Home equity loans: As with mortgages, your home is used to secure a home equity loan.
- Business loans: If you take out a loan to pay for equipment for your business, you could agree to use it as collateral to take out your loan.
Why does hypothecation matter?
Hypothecation matters because it’s your formal agreement that if you fail to meet the agreement — like making payments on your car or home — your property could get taken to pay for those missed payments. Missed payments can lead to a home foreclosure, leaving you with no place to live.
It’s essential to recognize in which instances 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 may 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 hurt your credit score and possible lending opportunities in the future, there’s no hypothecation or agreement to put up anything as collateral in these contracts.
What is rehypothecation?
Rehypothecation is when a lender uses your collateral as collateral of their own. If your lender needs to meet certain contractual agreements of its own, it might use your property to do so.
While possible, this practice isn’t as common as it was before the 2008 economic downturn. Because the collateral continues to get rehypothecated, it becomes less clear who really owns the asset.
You can avoid rehypothecation in investing by opening traditional brokerage cash accounts and not margin accounts. This means you’re avoiding borrowing money to make purchases, instead using your own funds.
The bottom line
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 and hold up your end of the agreement.
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 as soon as possible. Negotiating early alleviates the need to borrow extra money, like through a payday loan, which would only increase your financial burden on borrowing.