Unsecured loans, like credit cards, don't require anything up front from the borrower. However, secured loans, like mortgages or car loans, usually do. If you fail to make payments or default on this type of loan, your lender can use the collateral to pay off your outstanding balance in what's known as hypothecation. This helps protect the lender's risk.
Hypothecation is when you agree to provide an asset as collateral in exchange for a loan. As the borrower and owner of the asset, you won't give up title, possession, or ownership rights to the asset (or any income it generates). But you're still not technically the outright owner because the lender still retains the rights to seize collateral if the loan terms are not met.
For example, when you get a car loan, you agree that the car is used as collateral. If you can’t repay the loan, your lender may repossess the car. The bank technically owns the car.
Hypothecation is only used in secured loans, like car loans, home loans, or commercial loans. Unsecured loans, like personal loans or credit cards, do not use hypothecation.
Hypothecation occurs most commonly in home loans. Unless you buy a house with cash, you must take on a mortgage, which is a secured loan. In a mortgage agreement, your home is used as collateral, thereby solidifying hypothecation. If you fail to make mortgage payments, the lender can seize your home.
As we mentioned before, in hypothecation, you are the legal owner of the home, with your name on the deed and title, but you’re still in debt, and your house is still collateral for the loan.
Hypothecation and a mortgage aren’t interchangeable terms. Hypothecation is the pledging of an asset (like a house) as collateral for a loan in exchange for full ownership rights. In a mortgage, the property is used as collateral, but the lender places a lien on the property until you pay off the mortgage. You assume property ownership rights and responsibilities, but you don’t technically outright own the property until you satisfy the mortgage terms.
A hypothecation agreement gives a lender security and may make getting a loan easier for a borrower. Mortgage deeds or deeds of trust can also offer security, but the borrow doesn’t technically list an asset as collateral.
When you enter a hypothecation agreement with a lender, you’ll use a promissory note that outlines the terms of the agreement. The borrower lists the object they’re offering as collateral, as well as loan repayment terms. The borrower retains ownership and title of the asset throughout the loan period, so long as they continue to make on-time payments. If they fail to make a payment, the lender can seize the collateral immediately.
That’s why, if you’re ever in a tough spot financially, you should always pay your hypothecated loans first.
Hypothecation is common in commercial as well as residential real estate. However, in commercial real estate deals, you may have a few other options for collateral. Of course, you can use the property itself but some businesspeople would prefer to use another commercial property, vehicles, or even their primary residence as collateral. For big commercial properties, lenders may require multiple pieces of collateral.
Construction loans work a bit differently. Since the property that would be used as collateral hasn’t been built yet, a borrower must find other pieces of collateral besides the property itself.
Rehypothecation occurs when a lender uses your collateral as its own collateral to meet contractual agreements. This practice isn’t as common today as it was before the 2008 recession, when the housing crisis led to so many foreclosures, it was difficult to determine who really owned an asset.
You might think this sounds like it shouldn’t be legal but rehypothecation is sometimes included in the fine print of a loan. Banks and brokers like to use hypothecated collateral because it can help them secure a lower cost of borrowing or a rebate on fees. For instance, if a lender is pursuing a major commercial real estate project, they may use an apartment building you own through a hypothecated loan as collateral for the new loan. The newly created debt is called a derivative.
As you might imagine, rehypothecation is more common in investing than in real estate given the complexity of real estate ownership rights. Margin lending in brokerage accounts is a common form of hypothecation that becomes rehypothecated to allow banks (and individuals) borrow from a brokerage to make larger investments by leveraging existing account balances.
You can negotiate rehypothecation as banks and lenders must have permission from the owner of assets to do it.
Hypothecation happens in nearly every secured loan, you probably just didn’t know the name for it. Now you do, and you have a better understanding of how it plays into real estate transactions.
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