What Does Hypothecation Mean?

What Is Hypothecation?

Hypothecation occurs when a borrower agrees to use an asset to secure a loan without giving up possession of that asset. As long as you make your payments on time, you get to keep the collateral. If you miss payments, however, the lender can take the asset and sell it to recoup its losses on the unpaid loan.

Common examples of hypothecation include auto loans and mortgages, where the asset you're purchasing secures the loan, but those aren't the only places you may see it. Hypothecation may also be used in investing and for business loans.

Learn more: What Is Collateral?

How Does Hypothecation Work?

With hypothecation, you use collateral to secure a loan without giving it to the lender. In some cases, the asset you're purchasing acts as the collateral; in others, you use an asset you already own to secure the loan.

In each scenario, you own and maintain possession of the asset, and the lender has no right to it as long as you adhere to the terms of the loan agreement. However, if you don't meet your loan obligation, the lender can take possession of the asset and sell it to recover its losses.

Because hypothecated loans generally represent less risk for the lender, they may be easier to qualify for and interest rates tend to be lower. Loans that aren't hypothecated, such as unsecured personal loans, are riskier for lenders because you're not using collateral to secure the loan.

When a loan isn't hypothecated, the lender assumes more risk, which is often reflected in stricter credit criteria and higher interest rates.

Types of Hypothecation Agreements

Below are some common types of hypothecation agreements you may encounter.

Hypothecation for Mortgages

Unless you're making an all-cash offer, you need a loan to finance the purchase of a property. When you take out a mortgage, the property you're buying acts as collateral for the loan. As long as you make your mortgage payments on time, you get to live in your home, or in the case of a rental property, rent it to generate income.

But until your loan balance is paid in full, the lender may foreclose on the property, sell it and keep the proceeds if you can't make your payments. That's where hypothecation comes in, and it doesn't just apply to original mortgages. It also comes into play with home equity loans and home equity lines of credit (HELOCs) where your home is used to secure the loan or line of credit.

Tip: Foreclosure proceedings don't typically begin as soon as you miss a payment; they take time. If you experience a financial hardship that prevents you from making your mortgage payments, contact your lender immediately. Many have programs that may help you stay in your home and get caught up on payments.

Hypothecation for Car Loans

Auto loans are similar to mortgages in that the property you're buying—in this case a car—secures the loan. Make your payments on time until you've paid off your loan balance, and you can ride off into the sunset.

But because hypothecation is a critical element of an auto loan, if you default on your loan, the lender can repossess your vehicle and sell it to pay off the balance. They can also often charge you for repossession costs, and in some cases, require you to pay the difference between what they sold the vehicle for and your remaining loan balance if it was sold for less than what you owe.

Learn more: What to Do if You Can't Afford Your Car Payment

Hypothecation for Investing

Hypothecation may be used for some, but not all investments. For example, it doesn't typically apply to the contributions you make each month to your company-sponsored retirement plan. However, it does occur when you borrow money from a broker to purchase securities, and it can be risky.

When you borrow money to purchase securities, those investments act as collateral. If the value of the hypothecated securities (the ones you borrowed money to buy) drops below a certain threshold, the broker can sell them plus other investments in your portfolio to recoup its losses. This is known as a margin call.

The broker gets its money back and your account balance reflects the losses.

Hypothecation for Business Loans

There may be times when you need to put up collateral to secure a business loan. The collateral you pledge generally needs to be something the lender can easily sell to get its money back if you default, such as real estate, equipment, inventory or company vehicles.

This is a little different than hypothecation for a mortgage or auto loan because the loan isn't secured by the asset you're purchasing. However, if you're unable to make the payments on your business loan, the lender may seize the asset you pledged as collateral.

Pros and Cons of Hypothecation

Loans that include hypothecation have advantages and disadvantages. It's important to weigh both when considering your loan options.

What to Know About Getting a Hypothecation Agreement

Before taking out a loan that involves hypothecation, there are several things to consider.

1. Understand the risk. The lender has the right to seize the asset securing the loan if you're unable to make your payments. That means you could lose your home, vehicle, investments or business assets.
2. Get your asset appraised. Before a lender will agree to secure a loan with collateral, they typically want to know how much it's worth. This may require you paying for an appraisal out of pocket.
3. Review the agreement. Hypothecation loans may have added complexity that unsecured loans don't. Pay special attention to clauses that affect whether you need to insure a hypothecated asset, can sell it or otherwise place restrictions on how hypothecated assets must be handled.
4. Choose the right lender. Interest rates and loan terms can vary significantly between lenders. Getting quotes and comparing offers from multiple lenders can help ensure you get the best loan for you.

Frequently Asked Questions

The Bottom Line

Hypothecation is a common way lenders reduce their risk, making it easier for borrowers to qualify for a loan and get lower rates. But it adds risk for the borrower because they're agreeing to let the lender seize assets they put up as collateral if they're unable to make their payments.

If you're looking to apply for a loan that involves hypothecation, having good credit can help you secure a lower interest rate, higher loan amount or better terms. Check your FICO^® Score^☉ and credit report free from Experian to see where your credit stands.