Hypothecation in real estate enables one form of secured loans. It occurs when a borrower puts an asset as collateral with the lender to secure a loan.
As the loan is backed by collateral, it is one form of secured loan. Hypothecation offers certain benefits to both parties in the loan agreement.
The ownership of the pledged asset remains with the borrower unless a case of default on the loan occurs.
Definition
Hypothecation is the process of pledging an asset as collateral to secure a loan. The asset can be any tangible item including vehicles, houses, commercial property, etc.
Hypothecation in Real Estate
Hypothecation in real estate is the pledge of an asset to secure the loan or mortgage deal. The pledged assets can be movable or immovable large assets.
The legal ownership and usage rights with the asset remain with the borrower. The lender may use the right of seizure in case the borrower defaults on the loan.
During the loan terms, any income generated from the asset such as rental income will go towards the borrower only. The lenders have no claim over the income from real estate property to recover the loan installments or charges.
However, in the case of the borrower’s default or bankruptcy the lenders will claim the pledged property against the remaining balance of the loan.
How does it work?
Hypothecation can work as a loan agreement or a letter. In both cases, the purpose of the agreement between the lender and borrower is to secure the loan.
A borrower owning a house or commercial property can pledge it to secure a loan from the bank. The bank will approve the loan against the fair market value of the asset. The lenders do consider the applicant’s credit history, income profile, etc. as well. However, since the loan is backed by the asset, the bank may offer relatively relaxed terms to the borrower.
Similarly, the borrower facing a shortage with the down payment on a mortgage can use an asset to pledge. An asset worth equal to the remaining balance on down payment will be used as hypothecation.
The asset will remain under the borrower’s ownership unless a foreclosure happens on the mortgage.
Third-Party Assets as Pledge in Hypothecation
In commercial real estate, it is common to pledge an asset owned by a third-party. The third-party can secure their interests from the applicant independently of the primary loan deal.
The borrower may pledge a vehicle or property owned by a family member to secure the loan. In the case of default, the lender holds the same rights of foreclosure of the pledged asset.
Pros and Cons of Hypothecation for Borrower
The total cost of borrowing for secured loans is always less than unsecured loans. Hypothecation with a pledged asset secures a loan and reduces the risk. It means the lenders will charge lower interest rates with secured loans.
Borrowers may use any asset owned by family members in a hypothecation agreement. It offers greater flexibility in negotiating the loan or mortgage terms with the lenders.
The biggest risk with hypothecation is the risk of default. A secured loan means the lender holds the right to foreclosure and can seize the property in case of default.
A pledged asset does not guarantee to secure the loan, as the lenders evaluate credit history, income sources, and other risk factors as well.
Pros and Cons of Hypothecation for the lender
As we witnessed in the past with global financial crises, the lenders in the real estate were prone to the biggest risk of default. Hypothecation secures the lenders against such default risks.
Real estate loans and mortgages are often long-term agreements. The credit profile of the borrower can change over time significantly.
The interest rates and other costs also vary over time. Any lender would feel comfortable entering into a secured loan than unsecured loans.
Although the lenders do not hold the ownership rights, they can perform the lien in case the borrower fails to complete the loan terms.
Hypothecation difference from Mortgage Agreements
Both agreements pledge an asset such as a house or commercial property as collateral. However, still, both types of agreements differ in certain ways.
- A mortgage transfer the title of ownership to the lender, whereas the hypothecation retains the ownership for the borrower.
- Mortgages in real estate are usually made for the long-term.
- Hypothecation can occur with a third-party-owned asset as well.
The lenders retain the right of foreclosure in either agreement type. In case of default, the lenders can seize the property and perform the lien to recover the remaining balance on the loan/mortgage agreement.
