Meaning of Hypothecation
Hypothecation is a form of the charge against a specific asset. It occurs when the asset is provided as collateral in order to obtain a loan without giving the title rights, possession, or any other income generated by the asset.
But, in case of default or non-compliance with terms and conditions, the lender can seize the collateral asset. For example; In the case of a working capital loan from banks or financial institutions, the borrower can hypothecate its stock and debtors with the lender.
After deduction of the margin of safety, the lender arrives at the drawing power of the borrower which is the working capital limit. This may change depending on the book value of stocks and debtors.
Another example would be a rental property. It may undergo hypothecation as collateral against the mortgage issued by the bank. As the property remains collateral, the bank has no right upon the rental income borrower gets.
If terms and conditions do not comply on an ongoing basis, the banks can seize the property or penalize the borrower as necessary.
Why Hypothecation Matters?
Hypothecation is used to secure debt. It involves collateral and when the borrower defaults, the collateral is at risk of seizure. For instance, if the borrower company fails to pay the mortgage even if it owns property technically, the bank can still seize it.
Such a step is called foreclosure. A similar thing can happen for a car loan. Hence, hypothecation is important as it depicts the type of assets and to what extent a lender can repossess in case the borrower defaults in case of financial distress.
Advantages of Hypothecation
Hypothecation has certain advantages to its nature which allows flexibility to both borrowers and lenders. The advantages are explained below:
1) Retains ownership and possession
Ownership and possession of the property remain with the borrower in the case of hypothecation. The title transfer, ownership transfer, or possession transfer just does not take place in the case of hypothecation.
However, the lender does have the right to seize and extract the unpaid loan amount in case of default by the borrower or violation of terms and conditions by the borrower.
2) Availability of lower interest rates
When the borrower provides collateral for the loan, the loan gets cheaper. This is because the banks prefer providing secure loans. In the case of availability of collateral, the number of lenders who would like to give loans also increases.
Due to high competition brewing when the collateral is available, the interest on such loan is lower as compared to unsecured loan.
3) Small loans
Loan against hypothecation of the stock is generally done for a small number of loans. It becomes easy to understand, easy to use, and easy to compute payoff. Hypothecation is done for getting vehicle loans, working capital limits, and home appliance loans.
The nature of the loan against hypothecation is secure. Hence, this gives major benefit to such kind of loan as it is secure. The competition amongst lenders increases as they all want such types of loans. Hence, these loans are easily available.
Disadvantages of Hypothecation
1) Seizure of collateral.
If the borrower defaults in the payment of the loan taken or does not comply with the terms and conditions of the loan agreement on an ongoing basis, the lender has every right to seize the asset and realize the value of the unpaid loan.
The lender is forced to seize the collateral only in case the asset is classified as a non-performing asset. This happens, when the borrower has not paid the lender for three consecutive periods.
2) Legal suits
The lender has the capacity to take the borrower to court if the lender is not able to recover all the dues of the loan even after seizing and selling the collateral asset. Hence, the borrower has to face further legal consequences which can include penalty or imprisonment.
3) Compliance on a Regular Basis
The borrower has to comply with terms and conditions ongoing basis. For example; in the case of a working capital loan against stock and debtors, the borrower has to submit monthly stock and debtors statement failing which would result in a penalty.
Further, the terms may state that these statements be certified by chartered accountants on a quarterly basis as the case may be. This adds to the cost of the loan indirectly.
4) Credit rating
If the borrower does not comply with the terms and conditions of the loan agreement, there will be a decline in the credit score of the borrower and in the future, the ability of the borrower to take the loan will decline and he will be subject to a higher rate of loans.
These loans are dirt cheap due to easy availability. Hence, the borrower may take the loan even in the times when it is absolutely not necessary to take a loan.