If you finance a home or a car, lenders won’t approve your application without collateral or hypothecation. They need to know that you can afford the loan and that if you can’t that they won’t have a total loss.
The most common example of this is a home mortgage, but hypothecation occurs with car loans and investments too. Any loan that you put up collateral to make up for the risk of default uses this practice.
How Hypothecation Works
It’s easiest to provide an example so you see how hypothecation works.
Let’s use a mortgage for example. You apply to borrow funds to buy a home. The home is $200,000 and you put down $10,000, so you need $190,000. You have a low debt-ratio, so a lender agrees to loan you the money. But since it’s such a large loan amount, they want collateral – the house.
The lender couldn’t take a chance of lending you so much money without any guarantee of repayment.
So you buy the house and ‘own’ it, but because of the hypothecation, the lender can repossess the house if you default on the loan. Typically, lenders can take the home back after you miss 90 days of payments, sometimes longer – it depends on your agreement.
Another example is a car loan. When you secure auto financing, the lender provides the funds to buy the car in exchange for using it as collateral. Just like the home, if you don’t pay the auto loan, the lender can repossess the car.
The only type of loan in which hypothecation doesn’t occur is unsecured loans. Credit cards and unsecured personal loans are a couple of examples. You don’t pledge any collateral to get the loans, but you pay higher interest rates in exchange for the collateral.
Hypothecation in Investments
Loans to buy goods aren’t the only time hypothecation occurs. It can also occur with investments. If you’re an experienced investor, you may borrow money to invest more. This is called investing on margin.
When you invest on margin, you borrow funds to buy more investments (some money comes from your own portfolio). If the broker enforces a margin call, though, you agree to immediately sell the securities. That’s not all, though, you also put up some of your securities in your current portfolio as collateral, which is hypothecation.
How Hypothecation Affects You
So hypothecation is collateral – but why does that matter?
Let’s look at a mortgage or car loan. If you default on the loan, the lender repossesses the car or home – meaning you lose your car or home. Not only will you experience financial stress, which caused the default, you’ll also be without the collateral you put up and probably invested your own money in.
Hypothecation is risky in investing because you can lose a good amount of your portfolio. If the lender calls a margin call, you must sell the securities. If that doesn’t cover the loan amount, you may have to give up other securities in your portfolio too so that you cover the debt.
What is Rehypothecation?
There’s also such a thing as rehypothecation. We touched upon it when we talked about investments above.
Rehypothecation occurs when lenders use the collateral you put up for their loan to secure their own loan. This can happen multiple times down the line, which puts everyone in the ‘chain’ at risk.
If one person defaults in the chain, it could spur a chain reaction of selling securities, which not only affects each borrower in the chain but the overall market too.
When is Hypothecation Most Common?
You mostly see hypothecation with mortgages and car loans. These are the two largest investments most people make in their personal lives, but you’ll see it with investments too. It’s how you can secure a loan at reasonable rates while reassuring the lender that they won’t lose out on the deal.
Before you accept hypothecation, make sure you understand it. If you aren’t sure talk to a financial advisor. Know your rights and what could happen if you don’t pay your home or car payments and always make sure you can comfortably afford the loan.
Know the terms of the loan and the reasons the lender could repossess your belongings. If you aren’t sure, talk with an advisor to find out what you should do and how it would affect you financially.