Hypothecation is the action of pledging specific assets as collateral to obtain a loan. These securities may be in the form of real estate, different types of securities, or any other property that the lender deems acceptable as collateral. Along with securing loans for the purchase of property, such as with a mortgage, the hypothecation may also involve using the debit balance in a margin account to secure what is known as a margin loan.
With hypothecation, the borrower is allowed to retain possession of the asset or property that is pledged as collateral. In most cases, the borrower also remains the owner of record for the asset. The lender receives a lien that can be used to gain access to the asset in the event that the borrower defaults on the loan for any reason. This helps to reduce the degree of risk that the lender assumes in exchange for extending the loan.
For the borrower, hypothecation can often help make the process of financing a purchase much easier. Since the loan is secured by the pledging of some asset that the lender deems acceptable, the possibility of obtaining a more competitive rate of interest on the loan is increased. The lower interest rate will save the borrower money over the life of the loan, without having an impact at the outcome. Assuming that the borrower makes all loan payments on time, he or she eventually retires the loan and the lien on the pledged property is discontinued.
The process of hypothecation is extremely common in many loan situations. Mortgages are a prime example, with the property that is purchased by the borrower used as collateral for the mortgage loan. Businesses also engage in hypothecation when obtaining financing for the purchase of manufacturing equipment, vehicles, or other assets that are necessary to the ongoing operation of the company. Consumers sometimes use this arrangement in order to purchase various goods for the home, such as large appliances.
Investors may sometimes use the balance in a margin account as collateral, making use of the asset to secure the means to settle other debts or to finance some type of investment opportunity. As with other assets used in a hypothecation, as long as the margin loan is repaid according to terms, the balance in the account remains intact and eventually is released from any type of lien imposed by the lender. Should the borrower fail to pay off the loan in a timely manner, the lender can take full control of the balance in the margin account, and use those funds as he or she sees fit.
