What Is Hypothecation?

Defined broadly, hypothecation refers to the practice of pledging an asset as collateral for a loan while still retaining ownership, as is commonly done to obtain a mortgage on a house. Here is an overview of the various types of hypothecation and how it could affect you.

Hypothecation in lendingThe most common example of hypothecation is mortgage lending. Under the terms of a mortgage, the borrower technically owns the house, but since the house is pledged as collateral, the lender has the right to seize the house if the borrower cannot meet his end of the loan agreement -- also known as foreclosure.

Other types of loans also involve hypothecation, where the goods are legally owned by the borrower but can be seized by the creditor if necessary. Auto loans are generally secured by the underlying vehicle -- if you don't make your car payments, the finance company can repossess it. Business equipment is another type of property that is often hypothecated.

Hypothecation doesn't apply to certain types of lending, which are generally known as unsecured loans. For example, one type of loan without hypothecation is a credit card. If you stop making your credit card payments, the card's issuing institution may send your account to collections and eventually sue you in court in an effort to recoup their money. However, they will not show up at your house and take possession of the things you bought with the credit card.

Hypothecation in investmentsAnother common form of hypothecation is margin lending in brokerage accounts. When an investor chooses to purchase securities on margin, he or she is agreeing that those securities can be sold if necessary on a margin call. The other (fully owned) securities in the brokerage account are also used as collateral, which can be sold if the state of a margin account calls for it.

RehypothecationAlthough it doesn't usually concern consumers, sometimes an institution can rehypothecate the collateral pledged by its borrowers by posting it as collateral for one of its own obligations. If you use securities in your portfolio as collateral for your margin account, and your brokerage then uses those assets as collateral in its own trades, it is an example of rehypothecation.

This was a much more common practice in the years leading up to the financial crisis, but it still exists today. In the U.S., rehypothecation of collateral is limited to 140% of the amount of money loaned to the client, according to SEC regulations.

Why hypothecation matters to you You should be aware if hypothecation applies to any of your loans, as it dictates which of your assets could be at risk if you stop making your payments. If you have a mortgage, there is definitely a stipulation in your mortgage agreement that says your lender can take possession of your home if you stop making payments, and some of your other property, such as cars and boats, can also be subject to repossession.

In short, it pays to know which of your assets can be taken by lenders if times get tough, and which cannot.

The article What Is Hypothecation? originally appeared on Fool.com.

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