Hypothecation
Candlefocus EditorWhen a lender decides to hypothecate an asset, they will require the borrower to allow a lien or charge to be placed on the asset as a way to secure the loan and to ensure repayment. A lien is an interest in a particular asset, like a mortgage lien attached to a home. This lien gives the lender a claim to the asset if the borrower fails to make loan payments. If a borrower doesn’t pay the loan as stipulated, a lender can use the lien to force a sale of the asset, with the proceeds of the sale used to pay off the balance of the loan.
In mortgage lending, homebuyers often use hypothecation when taking out a mortgage loan. When the borrower signs a mortgage agreement, the property is considered to be hypothecated and the bank will register a charge against the title of the property. This charge confirms that the bank is the legal owner of the property until the loan is paid off. If the borrower defaults on the loan, the bank may take possession of the home and sell it to recover the funds.
In margin lending (also known as security-based borrowing), investors may hypothecate the securities they possess to a brokerage firm in order to borrow additional funds to invest. The investor is not required to transfer ownership of their securities to the brokerage firm; instead, they can hypothecate them, in which case they retain ownership while allowing the brokerage firm to own a security lien against the assets as collateral. As with mortgage hypothecation, if the investor fails to repay their loan as stipulated, the brokerage firm could liquidate the securities to recover its funds.
Unlike pledges, which usually involve full transfer of legal title and possession from the owner, hypothecation is an arrangement that is beneficial to both parties, as it allows borrowers to benefit from a lower interest rate and lenders to mitigate their risk of loss. Nonetheless, both parties should understand the terms of the loan agreement, including the possible consequences of default, before entering into a hypothecation agreement.