Hypothecation may not be a word you’ve heard before, but it describes a transaction you may have 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 frequently involve hypothecation, since it allows the lender to repossess the car or house if the borrower is later unable to pay.
There are, though, some more subtle details to understand about hypothecation, particularly if you’re in the market for a home loan. Read on to learn about hypothecation loans.
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. We’ll briefly talk about that later.)
As mentioned above, 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 paid the full purchase price in cash.
It’s important to understand that, just because the asset is offered as collateral, it doesn’t mean the owner loses legal possession or ownership rights of it. For instance, with an auto loan, the car is yours even though the lender might hold the title until the loan is paid off.
You also maintain your rights 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 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 your renters.)
Why Is Hypothecation Important?
Hypothecation makes it easier to qualify for a loan — particularly a loan for a lot of money — because the collateral makes the transaction less risky for the lender.
For instance, hypothecation is the only way that most people are able to qualify for a mortgage. If those loans weren’t secured with collateral, lenders might have very steep eligibility requirements before they would pay out hundreds of thousands of dollars for a home on a piece of land!
Unsecured loans, however, are possible. A personal loan is a good example.
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.
It’s a trade-off: Unsecured loans are riskier for the lender, so they tend to be harder to qualify for and to carry higher interest rates than secured loans.
On the other hand, if you compare a car loan and personal loan of equal length, you’ll likely be subject to a stricter eligibility screening to get the unsecured loan and pay more interest on it in the end.
Recommended: Smarter Ways to Get a Car Loan
Hypothecation in Investing
Along with hypothecation in the context of a secured loan for a physical asset, like a house or a car, hypothecation also occurs in investing — though usually only if you take on advanced investment techniques.
Hypothecation occurs when investors participate in margin lending: 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 should not worry about hypothecation in your investment portfolio. But you’ll want to know it can happen in investing, too.
Recommended: What Is Margin Trading?
Hypothecation in Real Estate
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.
Hypothecation also occurs with investment property loans. A lender might require additional collateral to lessen the risk of providing a commercial property loan. A borrower might hypothecate their primary home, another piece of property, a boat, a car, or even stocks to secure the loan.
A promissory note details the terms of the arrangement.
Recommended: 31 Ways to Save for a Home
Is Hypothecation in a Mortgage Worth It?
Given the 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 usually seen as a positive financial move. That’s because much of the money you pay into your mortgage each month ends up back in your own pocket in some capacity…as opposed to your landlord’s bank account.
As you pay off a mortgage, you’re slowly building equity in your home. Homes have historically tended to increase in value.
More broadly, homeownership can help build generational wealth in your family.
A Note on Rehypothecation
There is such a thing as rehypothecation, which is what happens when the collateral you offer is in turn offered by the lender in its own negotiations.
But this, as anyone who lived through the 2008 housing crisis knows, can have dire consequences. Remember The Big Short? Rehypothecation was part of the reason the housing market became so fragile and eventually fell apart. It is practiced much less frequently these days.
The Takeaway
Hypothecation simply means that collateral, like a house or a car, is pledged to secure 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.
Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.
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*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.
*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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