What is 'Hypothecation'

Hypothecation is legal term that refers to the granting of a hypothec to a lender by a borrower. In practice, the borrower pledges an asset as collateral for a loan, while retaining ownership of the assets and enjoying the benefits therefrom. The term comes from civil law; although its usage varies from jurisdiction to jurisdiction, it is nearly synonymous to a lien or mortgage.

BREAKING DOWN 'Hypothecation'

A hypothec can be created contractually (usually by an official deed) or by law (such as a builder's hypothec). In both cases, the result is a lien on the property and restrictions on its sale for the owner until the principal obligation of the grantor of the hypothec, such as the repayment of a loan, has been met. In the securities business, hypothecation also refers to securities in a margin account that an investor uses as collateral to borrow funds from a brokerage.

Practical Effects of Hypothecation

A lender who is the beneficiary of a hypothec has the right to seize the asset if the borrower cannot service the loan as stipulated by the terms in the loan agreement. It is commonly used as security for individuals who purchase houses. In France, the term "hypothèque" in the Civil Code is even translated as a mortgage. In Canada, the Civil Code of Quebec translates it as "hypothec."

A hypothec can be granted over any type of property, whether immovable (such as real estate) or movable (such as machinery). In most jurisdiction, hypothecs are published in a public registry so that potential creditors can see what, if any, other lenders have rights over an asset. For example, in Quebec, lenders can access the register of personal and movable real rights. It is usually legal to grant several hypothecs over the same asset. As a rule, in such cases, the rights of the lenders come in the order in which the hypothecs were published.

Advantages of Hypothecation for Borrowers

Since the practice of hypothecation provides security to the lender because of the collateral pledged by the borrower, the lender generally offers the loan at a lower rate of interest than on an unsecured loan. This is true of both mortgages and margin loans. While it enables the borrower to obtain loans on more favorable terms than unsecured loans, the borrower risks losing the asset if prices plunge precipitously and the loan cannot be serviced. For example, a record number of U.S. homeowners lost their homes to foreclosure in the wake of the 2006-2008 housing collapse and financial crisis, as home prices plunged and interest rates on mortgages rose.

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