What is hypothecation in real estate? How does it work?

Understanding what is hypothecation in real estate is crucial when you become a homeowner. Know that mortgages are a type of hypothecation loan. If you miss several mortgage payments in a row, the lender can foreclose on your home, leaving you without a place to live! 

So, what is hypothecation in real estate?

Hypothecation is when you use an asset as collateral for a loan without giving the lender the title to the property. That is to say, you agree to let the asset secure the loan, but you keep all ownership rights. You still fully own and can use the asset. The lender only has a claim on the asset if you default on the loan or break the terms and conditions. So, hypothecation is the lender’s safety net if you can’t pay back the loan or don’t follow the agreement.

In contrast, in a traditional mortgage, the property you buy secures the loan, but the lender holds the title. 

When you enter a hypothecation agreement, usually the asset is what you’re borrowing the money for. For example, with an auto loan, your car is the collateral. You get to drive the car, but if you can’t repay the loan, the lender can take it back.

Remember that hypothecation only applies to secured loans. You won’t find it with most personal loans since they’re unsecured. Credit cards don’t use hypothecation either for the same reason.

Why is hypothecation important?

Hypothecation is a formal agreement or a promissory note where you agree that if you don’t meet the loan conditions, your property could be taken to cover those missed payments. If you, as a property owner or real estate investor, are ever in a financial pinch and can’t pay all your bills, think about prioritizing the ones that are hypothecated. For example, you might want to make your home and car payments before your credit card payments to avoid losing those assets. While not paying your credit card can hurt your credit score and future borrowing chances, there’s no hypothecation agreement putting up your property as collateral in those contracts.

What’s the difference between hypothecation and a lien?

A lien is a legal claim on a property, which means you can’t sell or refinance it until the claim is resolved. Liens often come up with hypothecation. For example, if you’re paying off a mortgage, the lender has a lien on your property. This lien proves the lender’s right to take your home if you stop making payments.

When you get a mortgage, you agree to this lien. However, liens can also be placed on your property for other reasons, such as not paying taxes or other debts.

Where can you utilize hypothecation?

Hypothecation is a standard part of home loans. When you take out a mortgage instead of paying cash for your house, the home itself becomes collateral for the loan. Basically, even though you’re the one buying the house, the lender is giving you the money for it, and they need a backup if you can’t pay them back. If you fail to make your payments, the lender can take your home.

This also applies to other types of home-related financing, such as second mortgages, home equity lines of credit (HELOCs), or home equity loans. Here, you’re borrowing money based on the equity you have in your home and agreeing to use the house as collateral to get the funds.

Apart from residential real estate, you often see hypothecation in commercial real estate also. If you’re buying a commercial property, your lender might ask you to use your home or the property itself as collateral.

The same thing can happen with real estate loans for investment properties. Sometimes, lenders won’t give you a big loan amount unless you put up multiple pieces of collateral or additional collateral. For example a rental property along with your primary residence.

Outside of the real estate industry, hypothecation may also apply to auto loans where you put up your car, motorcycle, RV, or another vehicle as security for the loan. Or, business loans where you borrow money to buy equipment for your business. You might use that equipment (or other company assets) as collateral.

What are the advantages of hypothecation?

Even though you have to put up an asset as collateral to get a loan, hypothecation has its benefits:

• It makes it easier for you to get financing. Hypothecation lowers the lender’s risk, making them more willing to give you a loan. Without it, getting big loans, such as mortgages, would be tough.
• Loans backed by hypothecation usually come with lower interest rates compared to unsecured loans. Since the lender has your asset as security, they’re more confident they’ll get their money back, which makes borrowing cheaper.
• With hypothecation, you still own your asset. There’s no need to transfer the title or give up possession.

What are the downsides of hypothecation?

• While you still technically own and control the asset, hypothecation gives the lender a claim on it. If you can’t repay your loan or fail to meet the repayment terms and conditions, the lender can seize and sell your asset.
• If the lender can’t recover the full amount owed even after taking your asset, you might face legal action.
• Hypothecated loans often have longer terms, meaning you’ll end up paying more in interest over time. Even if the interest rate is lower, the total cost of the asset will be higher compared to if you had paid in cash.

Read more: What is rescission in real estate?

Key takeaway

Hypothecation is when you put up an asset, such as your house, rental property, or car, as security for a loan. The borrower retains ownership rights of the property in question. 

But if they can’t keep up with the loan payments, the lender can take that asset to get their money back. That’s why, it’s important to understand what is hypothecation in real estate and stay on top of these loan payments so you don’t risk losing what you’ve put up as collateral.

Written by Ramona Sinha. August 7, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.