Hypothecation refers to pledging an asset – granting a hypothetic – such as a house or car, as collateral on a loan, but the borrower still has ownership of that asset and enjoys its benefits, as long as he or she does not default. This type of hypothecation is commonly done to get a mortgage on a house.
The term is similar in meaning to a mortgage or lien.
The aim of hypothecation is to mitigate the lender’s or creditor’s risk. If the debtor is unable to pay, the lender possesses the collateral and can therefore claim its ownership, sell it and thus recover the money that was lent (or some of it).
Hypothecation is a situation in which an individual or company borrows money in relation to specific assets that become the property of the lender if the loan cannot be paid back.
A hypothetic is the right of the lender or creditor to take a borrower’s asset if a debt or obligation is not repaid, but in the meantime, that asset remains in the borrower’s possession.
According to ft.com/lexicon, hypothecation is:
“The pledging of assets as collateral to secure a loan. Margin agreements with brokers normally involve the hypothecation of securities.”
Hypothecation in mortgages and car loans
The most common example of hypothecation is a mortgage – a loan to purchase a house. Under the terms of the loan, technically the borrower owns the house, but since it is pledged as collateral, the lender – usually a bank – can lawfully seize the house if the borrower fails to keep up his or her mortgage payments – this is known as foreclosure.
Many other types of loans involve hypothecation. For example, when you borrow money to buy a car – auto financing – the car itself is pledged as collateral on the money borrowed. If you fail to make your auto-loan payments, whoever lent you the money is legally allowed to repossess it.
The hypothecation of tax is the dedication of the government’s revenue for a particular expenditure. Sometimes, it may refer to a government’s pledge to dedicate a particular tax to a specific area, such as sales tax on books for education expenditure, or or the tax on cigarettes for health spending.
Loans for the purchase of business equipment also typically involve hypothecation.
A hypothetic may be granted over any type of asset, such as real estate (immovable) or machinery or office equipment (movable). In some jurisdictions, a hypothetic refers just to movable assets – in such cases, a lien is for immovable assets.
In most countries or regions, hypothetics are published in a public registry so that potential lenders or creditors can see whether other lenders or creditors have rights over an asset.
In most jurisdictions, it is legal to grant more than one hypothetic over a single asset. If the borrower defaults on a loan or goes bankrupt, the rights of the creditors or lenders come in chronological order – the order in which the hypothetics were published.
Hypothecation does not apply to unsecured loans. In most cases, credit card loans are unsecured. If the borrower fails to meet his or her credit card repayment obligations, the lender will first refer that account to a collections agency, and eventually sue him or her in court in an attempt to recover the money.
If there is no hypothecation, the lender or creditor is not legally allowed to send people to the borrower’s home and take possession of things.
Hypothecation only applies to secured loans.
This quote is believed to have come from one of the Founding Fathers of the United States of America.
Hypothecation in investments
Hypothecation exists in investments, such as in margin lending in brokerage accounts. If an investor decides to buy securities on margin, it has been agreed that those securities may be sold if necessary on a margin call.
If the state of a margin account calls for it, other fully-owned securities in the brokerage account may also be used as collateral.
What is hypothecated tax?
Hypothecated tax is a tax where all or part of the money obtained is used for a particular purpose, rather than spent on several different things, i.e. taxes are earmarked for a specific purpose.
Hypothecated tax could be a clever way to overcome public hostility to paying more in taxes. If taxpayers are told that a specific proportion of their income tax will be spent exclusively on a popular cause, such as health or education, they may be more willing to part with their money.
The main drawback to making this kind of public-spending pledge is that it ties the hands of the government at times when the money could be better spent elsewhere in the public sector.
Cynical taxpayers say that government pledges on public spending are invariably broken. Civil servants, when under pressure from politicians, invariably find ways to move the goalposts and obscure the definition of the specific purpose for which a tax was hypothecated, allowing the government to regain total control over how public money is spent.
Rehypothecation occurs when the lender re-uses the collateral to secure its own borrowing. This occurs mainly in financial markets.
According to the Online Etymology Dictionary, the verb ‘hypothecate’ meaning ‘pledge (something) without giving up control of it, pawn, mortgage’ first emerged in the English language in England in the 1680s. It comes from the word ‘Hypothecat’, the past-participle from of Medieval Latin ‘Hypothecare’, which came from Late Latin ‘Hyptheca’, meaning ‘a pledge’.
The Latin word came from Greek ‘Hypotheke’, meaning ‘a pledge, deposit, mortgage,’. The Greek prefix ‘Hypo-‘ means ‘under, beneath’, while the suffix ‘-tithenai’ means ‘to put, place’.
In many European languages, their word for ‘mortgage’ has the same origin: hipoteca (Spanish, Portuguese), hypothéquer (French), Hypothek (German), ипотека (Russian), hipoteka (Polish), and hypotheek (Dutch).
Video – What is hypothecation
In this video, Mike explains what hypothecation is in the world of real estate.