What is Hypothecation?

Hypothecation is a tool you can use to secure a loan at a lower cost. It’s an approach to borrowing that offers reassurance to the lender, thereby lowering the interest rate you pay.

It occurs when you agree to use an asset as collateral when signing up for a loan.

For instance, when you take out a mortgage on your house, your home acts as the collateral. If you fail to make repayments, the lender – usually a bank – can repossess it and recover their losses.

Hypothecation doesn’t mean you give up your ownership rights. When the lender seizes the asset in the event that you fail to repay according to the agreement, they cannot claim income from the asset. For example, if it’s a rental property, they don’t get the money earned that way. However, they can sell it or increase their equity stake.

Unsecured loans are different. Lenders cannot automatically seize assets as part of the loan agreement, so interest rates are typically higher. That’s why personal loans cost more (on a per-dollar basis), than mortgages. However, there are still penalties for late repayment, including strikes on your credit score.

Types of Hypothecation 

Because hypothecation is just a general term to describe any situation in which the borrower exchanges collateral for lower interest rates, it pops up regularly. In this section, we will list some use cases:

Hypothecation in Mortgages

Hypothecation relates to collateral, not ownership. So, when you take out a mortgage, you own the property: It is your name on the title deed, and you can modify the asset as you see fit.

However, there is still a liability associated with it: Mortgage repayments. If you don’t meet them, the lender has the right to seize the property and sell it to make up the deficit. When this happens, it is called foreclosure. Even if your name is on the title deed, the lender can still take possession.

On the other hand, if you pay for a property with cash, hypothecation won’t happen to you, and you’ll own your asset outright.

Hypothecation in Investing

Investors will sometimes borrow money if they spot opportunities to make lucrative trades.

For instance, when traders sell short, they automatically acknowledge that they will need to sell their securities if the value of the account falls below a certain level. When there is a margin call, the investor agrees to sell the securities, regardless of the loss. That’s hypothecation with securities as collateral.

Hypothecation In Real Estate

Commercial real estate investors also frequently use hypothecation in a similar way to pay residential property owners. When investing in office buildings, retail units, or production facilities, lenders may ask them to put up an asset to guarantee the loan.

Interestingly, this doesn’t necessarily have to be the asset they’re using the loan to purchase. It could be a home or another real estate property they own.

Other Types Of Hypothecation

There are many other instances where you may encounter hypothecation, but they all work on the same principle. You exchange asset collateral for a lower interest rate on borrowed money.

Auto loans are a good example. These are affordable because hypothecation agreements stipulate that the lender can repossess the vehicle if you fail to make repayments.

It’s similar to business loans, too: If you don’t pay on time, the lender can seize the equipment you bought with the loan as collateral.

Why Does Hypothecation Matter?

Hypothecation, as discussed above, reduces the cost of loans. Without it, taking out a mortgage or borrowing money to buy a car would be significantly more expensive, as lenders would charge much higher interest rates to cover their risks.

Hypothecation is also helpful when prioritizing your budgeting and spending. If you have taken out a lot of loans, it generally makes sense to pay back the hypothecated ones first and avoid seizure.

Unfortunately, unsecured borrowing tends to be more expensive because of higher interest rates. So if you focus exclusively on paying installments on hypothecated loans, you may wind up with unmanageable debts from the unsecured ones.

What Is Rehypothecation?

Before the 2008 financial crisis, rehypothecation in investing was a common practice. Banks and investors would use their clients’ assets as collateral to back their own transactions. This practice allowed them to lower the cost of loans. Mortgage-backed securities were a good example of this in action.

However, the problem with rehypothecation is that it makes it unclear who actually owns what. If collateral continues to get rehypothecated, it distorts ownership and incentives, leading to the types of disasters that we saw at the peak of the financial crisis.