Hypothecation means offering an asset as collateral security to the lender. The ownership lies with a lender, and the borrower enjoys the possession. In the case of default by the borrower, the lender can exercise his ownership rights to seize the asset. The possession of the asset remains with the lender in case of a pledge, while it remains with the borrower in case of hypothecation. Common examples include the gold loan in case of pledge and vehicle loan in case of hypothecation.
Suppose Mr. X is a drug distributor (wholesaler) require a loan of Rs.10,00,000/- to increase the supply of medicine. He approaches his bank and asks for a debt called CC Loan. The bank doesn’t want to provide him with an unsecured loan that’s why Mr. X was asked to pledge his existing inventory with the bank as a security. Bank doesn’t keep the stocks with itself, however, the inventory will be hypothecated. In this case, neither possession nor ownership of stocks is transferred to the lender/ banks.
Important Points of Hypothecation
- The concept of hypothecation is defined in Section 2 of SARFAESI ACT 2002.
- Hypothecation is also created on movable properties only like pledge.
- Neither ownership nor possession of the movable properties/goods is transferred to the banks or financial institutions.
- In the case of hypothecation, the charge created is the equitable charge.
- If the borrower defaults the loan, the lender will first seize and take possession of assets then he can go for auction to recover the debt.
- The borrowers don’t have the rights to sell the hypothecated assets until the debt obligation is fulfilled.
What is Rehypothecation ?
- Rehypothecation is when a lender uses your collateral as collateral of its own. If your lender needs to meet certain contractual agreements, it might use your property to do so.
- While possible, this practice isn’t as common as it was before the 2008 economic downturn. Because the collateral continues to get rehypothecated, it becomes less clear who really owns the asset.
- You can avoid rehypothecation in investing by opening traditional brokerage cash accounts and not margin accounts. This means you’re avoiding borrowing money to make purchases, and instead using your own funds.
Reduction of down payment
The amount of down payment that a borrower owes can be reduced by hypothecating an asset because the borrower is pledging a high-value asset to guarantee his loan, rather than in a traditional mortgage, which uses loan-to-value ratios and credit score to vet a borrower. Hence, borrowers choosing to hypothecate an asset to secure a loan may be eligible for reduced down payments and this can make it easy to secure financing.
Retain the title
Borrowers can retain the title, i.e. total ownership rights of their hypothecated assets. If you are sure that you will be able to pay off your loan, you don’t need to worry about the possibility of a third party holding the title to your asset.
Greater security for lenders
Hypothecation provides security for lenders on high-risk loans, especially for commercial mortgages where the loan payment relies on the success of a commercial business.