What is Hypothecation in Real Estate?
Investing | Real Estate

What is Hypothecation in Real Estate?

Inexperienced residential real estate investors or lenders don’t know many things, especially information regarding different investment strategies for acquiring, financing, or selling valuable assets.

One of the more common strategies to finance properties today is real estate hypothecation, a useful tool for leveraging your existing assets for a secured loan or mortgage.

Real estate hypothecation agreements are rapidly becoming common in the market as more people are shifting away from unsecured loans due to poor credit scores and unstable income.

If you’re unfamiliar with this term, keep reading to learn what it is, how it works, and why it matters.

We’ll also explain how it differs from other investment strategies, like mortgages and pledges, as well as its pros and cons and risks associated.

What is Hyperthecation in Real Estate?

In a nutshell, real estate hypothecation is an investment strategy in which a borrower pledges a piece of collateral as leverage if they’re unable to meet the repayment terms of the mortgage or promissory note.

The most common pledged assets include the lender’s primary residence, rental property, vehicle, stocks, and other fixed/movable assets. However, unlike other strategies, hypothecation doesn’t allow lenders to either collect income from the pledged assets or transfer the ownership rights.

Instead, the process allows them to seize your property through foreclosure if you fail to pay the monthly payments or default. In the case of borrower defaults, lenders claim ownership rights of the property.

For example, if you put up rental property as additional collateral, the lender doesn’t have the right to collect income from it through any means. However, if you default on the payments, the lender can legally sell or collect rental income from it following foreclosure.

How Does Hypothecation Work?

Suppose you’re a borrower looking for an unsecured loan to buy a new house. You have $30,000 to use as a down payment, but the lender demands $40,000 to write the mortgage or loan agreement.

Instead of paying an additional $10,000 in cash, you can hypothecate a valuable asset, such as your car, boat, corporate bonds, stocks, inventory, or even Bitcoin, etc.

This way, you can secure a loan and possibly even lower your interest rate, depending on the asset you’re pledging. Meanwhile, the lender has a potentially equitable interest in the property only if you default. In simple words, you will have to relinquish your claims to the equitable title.

How and When Can You Use It?

Commercial lenders often require hypothecated or pledged collateral to underwrite a mortgage, so you need to make sure you can pay back the loan to avoid foreclosure. The best way to do this is by calculating your debt to income ratio and creditworthiness through a financial professional or real estate agent.

This way, you can not only get an idea of how much additional money you need to secure a loan but also estimate the value of your to-be-pledged assets. In many cases, it’s more about the property you’re looking to purchase. For example, many lenders consider the loan-to-value ratio among the most important factors and may even require you to hypothecate an asset regardless of your down payment or overall equity.

The best time to use this strategy is when you’re financing an expensive property with a longer-than-usual tenure. You can use other valuable assets to cut down your interest rates and increase your equity in the form of a larger down payment.

Why is it Important?

A hypothecation agreement is important because it legally grants the security of a loan if you fail to meet its repayment conditions. Therefore, you must recognize all the possible instances in which the lender can seize your property, such as your income, savings, revenue streams, and other financing initiatives.

For example, you have to be careful what you put on the line, especially if you miss payments. The last thing you want is to lose your home or car just because they were hypothecated. Ideally, it would be best if you prioritized these payments ahead of your credit card payments.

While this is a dilemma for many financially troubled individuals, you can improve your credit scores in the future, but if you default on your payments, you can’t reverse foreclosure. Once you lose ownership, the lender can do whatever they want with your property.

Mortgage vs. Hypothecation

Mortgage and real estate hypothecation are quite similar, and many investors often consider them the same thing. However, a hypothecation agreement is different in three ways.

The first difference lies in the equitable title of the loan agreement. In a mortgage, it’s the title or ownership of the property that serves as collateral. In a real estate hypothecation agreement, the ownership of the property remains with the borrower unless they default on the repayment.

Secondly, in hypothecation, the borrower pledges valuable assets as loan security, not their interest in the asset. And lastly, mortgage deeds typically last much longer than their counterparts.

Pledge vs. Hypothecation

A pledge is a form of collateral in which assets are held as security for repayment of a loan. It involves transferring the possession of property or asset, meaning the lender can legally sell them to recover the debt amount instead of going through foreclosure. In hypothecation, the possession always remains with the borrower, meaning the lender has no right to sell or generate income from it.

Assignment vs. Hypothecation

An assignment is a legal contract or agreement in which a borrower transfers some or all of their equity on a particular property (usually homes) or asset to cut the value of their purchase or reduce the interest rate on another unsecured loan. A real estate hypothecation agreement doesn’t involve sharing equity on any of the properties or assets.

Pros and Cons of Real Estate Hypothecation

Pros

Ownership Retention and Possession

Unlike a mortgage, pledge, or assignment, you maintain full equity and possession of your property and/or assets in a real estate hypothecation. So, you don’t have to worry about extensive paperwork involving ownership and title transfers. However, this is as long as you’re able to abide by the loan agreement. If you fail, the lender can seize your assets via foreclosure.

Ease of Availability

One of the major benefits this strategy offers borrowers is availability. Lenders and financial institutions are more likely to work with clients looking for a secured loan. Many institutions are neck to neck in competition and top each other by offering great repayment plans and interest rates. This loan type is secured with an asset; therefore, it carries significantly less risk than other loans. These loans are easier to secure, meaning there are hundreds of institutions you can apply to.

Better Interest Rates

When you offer a pledged asset as collateral for the loan, the lender can offer you a better repayment term with reduced interest rates due to immense competition in the real estate property market. Many banks and lenders may even overlook low credit scores if you offer an extremely valuable asset.

Smaller Loans

Mortgage deeds typically last for over a decade, an incredibly high tenure for any loan repayment. While lenders benefit from this in terms of interest, a lot can happen in a decade or so, especially financially, meaning there’s greater risk overall. In contrast, hypothecation loans are much smaller, not just in terms of amount but also tenure.

More Trust

Borrowers with hypothecated assets are more likely to pay back their loans since they’re putting a lot more on the line in terms of financial securities. In unsecured loans, the only thing lenders have to work with is a client’s credit history to determine the likeliness of repayment, which is much riskier.

Cons

Seizure following Borrowers Default

The biggest conditional drawback of this agreement is that the lender can legally seize your property or asset and sell it if you can’t pay the installments. They can continue to generate income from it for rental properties since they’ll get the ownership rights. Even if you’ve only failed to pay the last couple of payments, the lender can still seize it.

Legal Action in Case of Default

If your asset or property doesn’t make up for all the amount, you owe the lender, can legally sue you for the remaining amount. Possible consequences in this scenario include huge penalties or imprisonment.

Strict Terms and Conditions

Even with the ongoing competition in the market, borrowers still have to agree and comply with institutions’ mostly one-sided terms and conditions. For example, if your hypothecated asset is a stock, you may be required to submit performance statements every month. If you don’t comply with this, you may be fined a heavy penalty.

Worsened Credit Rating

Borrowers usually default on their payments due to financial problems, which ultimately reduces their credit scores further. Not only does this situation take away your existing assets, but it also makes borrowing difficult to procure new ones.

Extra Expenses

Many people with great credit scores and assets in the bag opt for investing in more properties due to lower interest rates. In many cases, unnecessary buying can lead to higher taxes and mismanagement. You still have to pay in installments with interest which increases the price of the property further. Instead, buyers should consider cash property purchases.

How to Write a Real Estate Hypothecation Agreement

The terms of a real estate hypothecation agreement will change depending on the value of your purchase, location, lender, and your financial background. The process also involves several risk factors borrowers must consider to prevent them from occurring.

The biggest risk for lenders involves allowing prepaid securities like treasury bills. Since they don’t have partial or full ownership rights to them, the borrower can legally sell this asset, meaning the lender loses their leverage.

Some borrowers can use the same asset for different loans, which can potentially lead to complex legal disputes in the case of defaults. Lastly, the collateral might not always meet the total cost of the property the borrower is purchasing, meaning lenders can lose a lot of money depending on the number of payments the borrower makes.

Whether you’re a borrower or a lender, here’s what you need to include in a real estate hypothecation agreement:

  • The full names of the applicant and lender, along with their contact information and address.
  • Financial statements including all the details of the debt, including the interest rates.
  • Preferred payment method/s and schedule
  • Ownership documents of the assets to be used as collateral, including their value estimation.
  • Conditions and remedies in the case of a default.
  • Liability of every individual involved in the agreement, including their responsibilities in detail.
  • Jurisdiction.
  • A detailed document on dispute resolution, if any.
  • Signatures of all parties along with the date.

The form of collateral you’re putting on the line would also make a huge difference to your application.

For example, many lenders prefer fixed assets such as a rental property or other acquired space. Cars are prone to accidents and loss of value due to wear and tear, and lenders might consider this risky.

Secondly, the stock market is incredibly volatile, which means the stock valuation depends on its performance.

Plus, buying and selling stocks is what you do in the investment market, so there is no way institutions will take on that much risk.

Frequently Asked Questions About Hypothecation in Real Estate

How do I get a hypothecation agreement?

The easiest and smartest way to get a hypothecation agreement is by talking to your bank. However, this depends on your income to debt ratio, so not every bank might agree to this transaction, so you’ll need to look for options in other financial institutions. Speaking to an experienced real estate agent can help you save time since they usually have connections with reputable institutions.

What is the Difference Between a Mortgage and Real Estate Hypothecation?

A mortgage is simply a loan used to purchase real estate. Real estate hypothecation, in contrast, involves pledging a valuable asset to serve as additional collateral for borrowers with low, low credit scores or unsteady income.

When Can You Use a Hypothecation Agreement?

Most property dealers or brokers use this agreement to prevent subleasing, whereas lenders use it to secure a mortgage or property construction loan. However, this agreement is only recommended for lenders with a poor financial status.

Is it Necessary to Remove Hypothecation?

Most real estate agents recommend removing the hypothecation in time to ensure that the insurance money doesn’t go to the bank in case of property damages.

Is Hypothecation Right for Me?

Hypothecation is an important financial decision that involves many risks considering you’re putting your assets to secure financing. Whether you put your primary residence or other assets to have enough money, there’s a chance you might lose them. Hence, it would help if you spoke to a financial professional beforehand to ensure you make the best decision possible.

What Happens if a Borrower Defaults on the Loan?

If a borrower defaults on their payment, the assets they put up as collateral will be seized by the lender, who can do whatever they like with them.

Can Your Lender Generate Income from Your Rental Property?

If your rental property is a hypothecated asset, then the lender cannot legally earn income from it unless you default on the payments and they seize it.

Summary

Borrowing money to finance any initiative or purchase involves a certain amount of risk. Luckily, there are ways you reduce that risk, especially when investing in real estate property.

With a hypothecation agreement, you can easily use your assets and property to secure a loan not only faster but with better terms. However, it would help if you spoke to an experienced real estate agent to explain all the risks involved.