Hypothecation is the practice of pledging collateral in order to secure debt. This comes up most often in mortgage lending, but it can apply to any kind of debt. It shows up in investing, but hypothecation and riskier rehypothecation can have consequences for homeowners. Learn the basics of hypothecation and how it works.
Hypothecation: The Basics
For example, when you take out a mortgage on a home, you technically own the home. But the bank actually uses it as collateral in case you deault on your payments. Or when you take out a loan when buying a car, that loan is based on the collateral provided. In short, your car. That means that though you technically own your car or home, the bank or loan holder can seize it should you fall behind on your payments.
Anytime you pledge collateral as a means to secure a loan, it involves hypothecation. This is unlike an unsecured loan, which lenders issue based primarily on your creditworthiness, among other factors
Hypothecation in Investing
For different reasons, hypothecation can also pertain to your investment portfolio. Hypothecation investing occurs when an investor takes part in margin lending in brokerage accounts. That’s because when an investor buys stocks or other securities on margin, they are actually borrowing funds from a broker to do so. They automatically agree to sell these securities in the event of a margin call.
Remember, a margin call is when an investor borrows money from a broker to make an investment (i.e. margin lending) and the investor’s ownership falls below a certain threshold, also called a maintenance margin.
But where does collateral come in? The other assets within the brokerage account that the investor fully owns serve as collateral and can be sold to cover losses.
Keep in mind that sometimes lenders can use an investor’s collateral as collateral for one of their own obligations, also called rehypothecation. This can sometimes create market risk, depending on how many times the assets have been rehypothecated.
Why Hypothecation Matters
First, we’ll talk about why hypothecation matters for those using it to secure debt. Putting it simply, hypothecation matters to a borrower because it involves collateral. In other words, if you borrow funds with collateral and default on that debt, whatever you used as collateral is at risk.
For example, if you fail to pay your mortgage, even though you technically own your home, your bank or lender can still seize it. This is called foreclosure. The same goes for your car loan. If you engaged in hypothecation, i.e. using collateral to obtain better financing for your vehicle, you can still lose your car is you fail to make payments. So hypothecation matters to borrowers because it indicates which of their assets a lender can repossess in the event of default or financial distress.
It also matters in the investing world. Remember, hypothecation in investing is when an investor purchases securities on margin. In that agreement, they can sell these securities in the event of a margin call. Also, they can cover losses by selling other assets in the brokerage account. That means that with hypothecation in investing comes a certain amount of risk.
This is when lenders meet obligations by using your collateral as collateral. Other lenders use that collateral to meet their owns obligations, and so on. Meanwhile, lenders don’t have to notify you if they are engaging in rehypothecation with your collateral.
That means that risk compounds across the market when rehypothecation occurs. A lender uses collateral from one borrower, then another lender uses that rehypotecated collateral, and so forth. However, if one borrower defaults, it can start a chain reaction of security sales. This can negatively impact the market.
The Bottom Line
Hypothecation is the practice of securing debt by pledging collateral. It occurs most often in mortgage lending. For example, when you secure a mortgage, you technically own your home. But it is also collateral for that loan. That means lenders can reposses it if you default on payments.
Rehypothecation is when a lender uses an investor’s collateral as collateral for one of their own obligations. It can negatively affect the market. Hypothecation tells borrowers which of their assets a lender can repossess in the event of default.
- If you aren’t sure how hypothecation affects your home or investments, a financial advisor may be able to help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Hypothecation can affect just about any secured loan, including home equity loans. If you want to consider more options or different stakes before taking out a personal loan, consider consulting SmartAsset’s personal loans guide for costs and comparisons.
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