Hypothecation occurs in lending when a borrower uses an asset as collateral to secure a loan. While it may be a standard requirement for certain types of loans such as mortgages and auto loans, it isn’t required for all forms of credit.
Understanding how hypothecation works, how it helps you, and its potential drawbacks can make it easier to make the right decisions about how to borrow money.
Definition of Hypothecation
Hypothecation is the act of pledging an asset as collateral to secure a loan. You don't lose possession or ownership rights of the asset, but if you don't make your loan payments on time, the lender may choose to seize the asset through repossession or foreclosure.
Hypothecation is a standard requirement with mortgage loans and auto loans, in which your home and vehicle, respectively, act as collateral. However, it can also occur with secured personal loans, secured credit cards, small business loans, and margin lending in a brokerage account.
Hypothecation reduces the risk to creditors because it creates an opportunity for them to recoup some or all of the loan amount if borrowers default.
How Hypothecation Works
When a borrower signs a loan contract, they agree to pay the loan as scheduled in the contract. With hypothecation, the borrower pledges an asset as collateral. As long as they make payments on time, they'll continue to get to use the asset they used to secure the loan and take advantage of their ownership rights. However, if the borrower defaults on loan payments, the creditor has the right to seize the asset from the borrower. It can then sell the asset to get its money back.
For example, if you buy a house using a mortgage, you'll typically use the property as collateral to secure the loan. You'll get to live in the home and enjoy any appreciation in value the property experiences over time. But if you stop making payments, the lender may choose to foreclose on the home, kick you out, and sell it to recoup the amount you owed.
With investing, hypothecation typically occurs when an investor buys on margin or engages in a short sale. When this happens, the investor enjoys any gains they may earn on their trades. However, if the investor experiences losses and a margin call occurs, the broker can sell the securities to cover those losses.
Alternatives to Hypothecation
The primary alternative to hypothecation is to pay cash for an asset instead of financing it. This can be easier with less expensive assets such as a car, but it can be challenging for many people to buy a home without a mortgage.
For investors, the only way to avoid hypothecation is to avoid trading on margin or engaging in short sales.
Short selling in particular is risky because the potential for loss is unlimited, so avoid it unless you can afford to lose your entire investment.
Hypothecation vs. Rehypothecation
Rehypothecation is a more obscure concept that creates a derivative lending product.
|A borrower pledges collateral to secure a loan||A lender uses hypothecated collateral to secure lower borrowing costs and fees in their own transactions|
|Remains a standard practice for mortgages, auto loans, margin trading, and more||Not as common anymore due to the negative impact during the 2008 financial crisis|
Pros and Cons of Hypothecation
Makes it possible to afford large purchases
Can help reduce the cost of borrowing
Can help a borrower qualify with less-than-stellar credit
The borrower may lose the asset if they default
The application process can be more complicated
- Makes it possible to afford large purchases: For many people, it may be impossible to purchase a vehicle or a home without financing the transaction.
- Can help reduce the cost of borrowing: Choosing to secure some types of loans could help you score a lower interest rate than if you were to choose an unsecured loan.
- Can help a borrower qualify with less-than-stellar credit: With hypothecation, creditors can afford to accept borrowers with lower credit scores because there's no risk of losing all of their money, compared to an unsecured loan.
- The borrower may lose the asset if they default: Losing your home or your vehicle can be devastating, so it's crucial you always make payments on time. And if you're investing, it's important to understand the risks associated with margin trading and short selling before you engage.
- The application process can be more complicated: Mortgage lenders typically require an appraisal and an inspection before agreeing to finance a purchase. These processes cost the borrower money and can take extra time. Some auto lenders may also require an appraisal, especially with refinance loans.
Is Hypothecation Worth It?
Hypothecation has both advantages and disadvantages, but when it comes to buying a home, it's generally the only way to go unless you can afford to pay cash. The same goes for a vehicle, which you may need to get to work or school.
While the application process for a secured loan can be a bit more complicated than if you were getting an unsecured loan, you can avoid having the asset seized if you make your payments on time throughout the repayment period.
If you're considering hypothecation with your brokerage account, it can be worthwhile because it can allow you to leverage your portfolio for more gains. But if you're not an experienced investor, consider taking time to learn about margin trading and short sales and the risks associated with those transactions before you wade into these waters.
- Hypothecation involves pledging collateral to secure a loan.
- It's generally required with mortgage and auto loans but can also occur with other types of loans.
- Hypothecation also occurs with margin trading and short selling in a brokerage account.
- Hypothecation can make it easier to get approved for a loan, and the borrower retains possession and ownership rights of the asset.
- If the borrower defaults or experiences a margin call, they may lose the asset they used as collateral.