Hypothecation may be a word you’ve never heard, but it describes a transaction you’ve probably participated in.
Hypothecation is what happens when a piece of collateral, like a house, is offered in order to secure a loan. Auto loans and mortgages involve hypothecation since the lender can repossess the car or house if the borrower is unable to pay. There are, though, some more subtle details to understand about hypothecation (and rehypothecation), particularly if you’re in the market for a home loan.
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What is hypothecation?
Hypothecation is essentially the fancy word for pledging collateral. If you’re taking out a secured loan (one in which a physical asset can be taken by the lender if you, as the borrower, default), you’re participating in hypothecation. (Hypothecation is also possible in certain investing scenarios, which we’ll talk briefly about later.) Some of the most common hypothecation loans are auto loans and mortgages. If you’ve ever purchased a car, it’s likely you have (or had) a hypothecation loan unless you were able to pay the full purchase price in cash.
Importantly, just because the asset is offered as collateral doesn’t mean that the owner loses legal possession or ownership rights of that asset. For instance, with an auto loan, the car is still yours, even though the lender might hold the title until the loan is paid off. You also maintain your right to the positive parts of ownership, such as income generation and appreciation. This is perhaps most obvious in the case of homeownership. Even if you’re paying a mortgage on your property, you still have the right to lease the place out—and you can still collect the rental income. However, the lender has the right to seize the property if you fail to make your mortgage payments, which would be a bad day for both you and the renters alike.
Why is hypothecation important?
Hypothecation makes it easier to qualify for a loan, particularly a loan for a lot of money, because the collateral means the transaction is less of a risk for the lender. For instance, hypothecation is the only way that most people are able to qualify for mortgages. If those loans weren’t secured with collateral, lenders might have very steep eligibility requirements to lend hundreds of thousands of dollars!
There are loans where hypothecation is not present, however. They are also known as unsecured loans. A personal loan is a good example. Because unsecured loans are riskier for the lending institution, they tend to be harder to qualify for and carry higher interest rates than secured loans.
It’s a trade-off: With an unsecured loan, you’re not at risk of having anything repossessed from you, and you can use the money for just about anything you want. On the other hand, if comparing, say, a car loan and personal loan of equal length, you’re likely to pay more interest over the life of the unsecured loan and be subject to a stricter eligibility screening to get the loan in the first place.
Hypothecation in investing
Along with hypothecation in the context of a secured loan on a physical asset, like a house or a car, hypothecation can also occur in investing, although usually not unless you’re taking on more advanced investment techniques. Hypothecation occurs when investors participate in margin lending, which involves borrowing money from a broker in order to purchase a stock market security (like a share of a company).
This technique can help active, short-term investors buy into securities they might not otherwise be able to afford, which can lead to gains if they hedge their bets right. But here’s the catch: The other securities in the investor’s portfolio are used as collateral and can be sold by the broker if the margin purchase ends up being a loss.
TL;DR: Unless you’re a well-studied day trader, buying on margin probably isn’t for you and you probably don’t have to worry about hypothecation in your investment portfolio. But you should know it can happen in investing, too!
Hypothecation in mortgage
As mentioned above, a mortgage is a classic example of a hypothecation loan: The lending institution foots the six-digit (or seven-digit) cost of the home upfront but retains the right to seize the property if you’re unable to make your mortgage payments. Given the staggering size of most home loans and the risk of losing the home, you may wonder if taking out a mortgage is worth it at all.
Even though any kind of loan involves going into debt and taking on some level of risk, homeownership is still often seen as a positive financial move. That’s because much of the money you’re paying into your mortgage each month usually ends up back in your own pocket in some capacity as opposed to your landlord’s pocket.
When you pay a mortgage, you’re slowly building equity in the home. And since most homes have historically tended to increase in value, or appreciate, you can often end up making a profit even after factoring in whatever interest you pay on the mortgage, most or all of which is likely tax-deductible.
A note on rehypothecation
There is such a thing as rehypothecation, which is what happens when the collateral you offer is then, in turn, offered by the lender in its own negotiations. It’s like hypothecation inception. We have to go deeper.
But this, as anyone who lived through the 2008 housing crisis knows, can have dire consequences. Remember The Big Short (the book-turned-movie about the housing crisis)? Rehypothecation is part of the reason the housing market became so fragile and eventually fell apart entirely and thus is practiced much less frequently these days.
Hypothecation is the process in which a piece of collateral, like a house or car, is offered as part of the negotiation of a loan. Mortgages are a classic example of hypothecation, and hypothecation is the reason most of us are able to qualify for such a large loan.
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