“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, such as 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.
Note: SoFi does not offer hypothecation. However, SoFi does offer home equity loan options.
Table of Contents
Key Points
• In a secured loan, hypothecation means pledging collateral that the lender can repossess if you fail to pay off the loan.
• You maintain your ownership rights on hypothecated property, including any income you earn off of it.
• Hypothecation makes it easier to qualify for a loan and get better interest rates.
• Hypothecation can also be used in investing, but it’s not recommended unless you’re a well-studied day trader.
• A mortgage is a well-known example of a hypothecation loan that allows you to build equity in your home and increase its value.
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. 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 will 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 often 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
Hypothecation also exists in investing in the form of margin trading, a high-risk strategy advanced investors may use.
Hypothecation occurs when investors use a margin account to borrow money from a broker in order to purchase stocks or other types of assets. Margin traders use cash deposited in the account and the securities in their portfolio as collateral for the loan, and they must also pay interest on the amount borrowed.
Trading on margin increases investors’ purchasing power, enabling them to make larger trades than they otherwise could in an attempt to enhance their returns.
But here’s the catch: Margin trading also comes with the risk of amplifying losses. If the price of a stock purchased on margin moves in an adverse direction, and the value of the margin account falls below the required maintenance margin, the investor must cover the loss. If they can’t, they may be forced to liquidate their securities to make up for the deficit.
Margin investing is generally only suitable for experienced traders comfortable with the risk of seeing substantial losses. But it’s helpful to know hypothecation is present 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, such as 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.
FAQ
What is the difference between hypothecation and pledged assets?
Both hypothecation and pledged assets refer to using something as collateral to secure a loan. However, pledging involves transferring the asset to the lender, while hypothecation allows you to retain ownership.
What are the risks of hypothecation?
The greatest risk is that if you don’t repay your loan, the lender has the right to repossess the hypothecated asset. Some lenders may also place restrictions on the asset or loan terms, such as mandating that a loan be repaid in full if the property is sold.
What is an example of hypothecation?
One example is taking out a mortgage loan on an apartment building using the property as collateral. Even as you pay off the mortgage, you can collect rental income on the property. However, if you fail to repay the loan, the lender has the right to seize the property.
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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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