Hypothecation: Definition and How It Works, With Examples

What Is Hypothecation?

Hypothecation occurs when an asset is pledged as collateral to secure a loan. The owner of the asset does not give up title, possession, or ownership rights, such as income generated by the asset. However, the lender can seize the asset if the terms of the agreement are not met. Hypothecation is different from a mortgage, lien, or assignment.

Hypothecation in Mortgages

Hypothecation occurs most commonly in mortgage lending. A mortgage is a type of loan that's secured by an underlying property. The borrower technically owns the house, but because the house is pledged as collateral, the mortgage lender has the right to seize the house if the borrower cannot meet the repayment terms of the loan agreement—which occurred during the foreclosure crisis.

Auto loans are similarly secured by the underlying vehicle. Unsecured loans, on the other hand, do not work with hypothecation because there is no collateral to claim in the event of default. As hypothecation provides security to the lender because of the collateral pledged by the borrower, it is easier to secure a loan, and the lender may offer a lower interest rate than on an unsecured loan.

Hypothecation in Investing

Margin lending in brokerage accounts is another common form of hypothecation. When an investor trades on margin, they're borrowing money from the brokerage to do so. This can allow them to leverage their existing account balances to make larger investments and potentially net larger profits on the sale of securities.

This type of hypothecation can be risky, however. When an investor chooses to buy on margin or sell short, they are agreeing that those securities can be sold if necessary if there is a margin call. The investor owns the securities in their account, but the broker can sell them if they issue a margin call that the investor cannot meet to cover the investor's losses.

This can be costly for the investor because it can amplify losses well beyond the initial investment made. For that reason, it's important to understand how margin trading works and what hypothecation could mean for you on a personal level.

Examples of Hypothecation Agreement

Hypothecation in real estate is most often associated with mortgage loans. A rental property, for example, may undergo hypothecation as collateral against a mortgage issued by a bank. While the property remains collateral, the bank has no claim on rental income that comes in; however, if the landlord defaults on the loan, the bank may seize the property by initiating a foreclosure proceeding.

The use of hypothecation in real estate agreements can offer some reassurance to lenders who may want to mitigate risk when loaning money. If the borrower doesn't pay for any reason, the bank can potentially recoup some of its losses if it's able to foreclose and then resell the property later. In that sense, hypothecation aids in stabilizing the mortgage lending industry.

Hypothecation can also work in favor of borrowers. By entering into this type of agreement, borrowers may find it easier to obtain mortgage loans with a smaller down payment or lower credit score requirements. They may also be able to qualify for more favorable interest rates because the lender is assuming less risk.

Hypothecation in Commercial Real Estate

Hypothecation in commercial real estate is the same as it is in residential real estate lending. The borrower posts collateral in order to secure a loan. So again, an investor who's borrowing to purchase a rental property, such as an apartment building or duplex, would use the property itself as collateral for the loan.

Construction loans in commercial real estate work a little differently. Because the property that would otherwise serve as collateral has yet to be built, the borrower would need to provide other property as substitute collateral. The same rule, however, would apply with regard to default. If the borrower fails to pay the loan, the lender could claim ownership of the collateral.

What Is Rehypothecation?

When banks and brokers use hypothecated collateral as collateral to back their own transactions and trades with their client’s agreement, in order to secure a lower cost of borrowing or a rebate on fees, this is called rehypothecation. For example, the lender may use an apartment building offered as collateral for a commercial real estate loan as collateral for a new loan. This newly created debt is now a derivative.

Rehypothecation is regulated by the Securities and Exchange Commission. Banks and lenders must have permission from the owner of the property or assets to do this.

The Bottom Line

Hypothecation often applies in real estate lending transactions, in which a property is used to secure a loan. But it can also be used in other types of loan situations as well as investing. If you're entering into a loan agreement that includes hypothecation, it's important to understand the potential consequences if you fail to uphold your financial obligation to the lender.