There are many different financing strategies you can use throughout your career as a real estate investor. But one of the most important tools in your kit is hypothecation, which is a common and advantageous financing strategy for commercial real estate investing. Additionally, hypothecation can be used to leverage your assets in unique ways so that you obtain more favorable mortgages or loans for residential real estate.
If you aren’t sure how to start using hypothecation in real estate, you’ve come to the right place. Let’s take a look at how hypothecation works and whether you should use it.
What is Hypothecation in Real Estate?
In a nutshell, hypothecation in real estate is an additional term or promissory note added to a loan/mortgage. It means that a borrower pledges some collateral to acquire a loan. Collateral for these loans can include rental properties, purchased housing, vehicles like cars or boats, and financial instruments like stocks or bonds.
Like a typical secured loan, the collateral for real estate hypothecation guarantees that the lender will get something out of the deal if the borrower fails to pay back the loan or promissory note.
Note that hypothecation doesn’t give ownership rights for the collateralized asset to the lender. The lender also isn’t allowed to collect potential income from the asset or property (i.e., if you pledge a rental property to a lender as collateral for your loan, they don’t get to collect rent unless you default and they seize ownership of the rental property).
Instead, hypothecation serves more as a lien against the collateral. This gives the lender the right to seize the asset or property through the foreclosure process if the investor defaults on the loan in question.
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How Does a Hypothecation Agreement Work?
To use hypothecation, a hypothecation agreement is written using a promissory note, which details the terms of the arrangement. On that note, the borrower lists the object(s) or asset(s) they plan to use as collateral for the loan. They also list the terms of the loan repayment, such as the minimum payment amount, when the loan will be paid off in full with interest. The note is added to an existing or forthcoming mortgage or other loan.
The hypothecation agreement states that the borrower keeps the ownership and title of the collateralized asset; the lender can only use the option to seize the assets through foreclosure if they default.
This is the key factor to remember when considering a hypothecation agreement: the collateral in the agreement is not owned by the lending party. It is only seized if the borrower defaults on the loan and its terms.
Why Use Real Estate Hypothecation?
There are several significant reasons why real estate investors often use hypothecation to secure favorable financing terms or arrangements.
For one, hypothecating an asset in real estate may reduce how much you need to pay for a down payment on a piece of real estate. Why? With a traditional mortgage, the borrower can only use their credit score and other intangible factors like their loan-to-value ratios to secure the mortgage. Since a hypothecation agreement uses collateral, the lender may agree to a lower down payment since they take on less risk than they would normally. Because of this, some investors – even those with enough cash to pay a down payment – will hypothecate an asset.
In many cases, commercial financial lending institutions will intentionally ask for the hypothecation of a valuable asset before offering a loan. Again, this serves as extra security for high-value commercial real estate properties. Some real estate investors can use these offers to acquire properties they would not be able to out-of-pocket.
Hypothecation can be advantageous if a borrower doesn’t have much experience with mortgages. A hypothecated asset provides a lender with extra security and can let a borrower buy a home or piece of real estate that they wouldn’t be able to with a low credit score, low net worth, or simply not a lot of successful history in real estate investing so far.
A hypothecation agreement may be used in residential real estate if a borrower needs a loan from a bank or a similar lending institution, but the lender isn’t comfortable with various aspects of the mortgage agreement. This can include the debt to income ratio of the borrower or other factors.
If a real estate investor needs a lower interest rate for a mortgage, they may offer to hypothecate an asset in exchange. Suppose they feel secure in their ability to pay back the loan on time without any it to their credit score. In that case, they could save money this way since they will pay less in interest over the loan’s term and never have to worry about their collateralized asset(s) ever actually being seized.
Example of Hypothecation in Real Estate
Still not sure how exactly hypothecation in real estate works? Let’s break down a detailed example step-by-step.
Say that you want to purchase a new rental property, but you need a loan because you don’t have the money to pay for the property out-of-pocket. You only have $50,000 you can use as a down payment. However, the lender for the property’s mortgage loan needs $75,000 to feel secure writing the mortgage.
That’s quite a hefty sum! Instead of gathering another $25,000 (which could take weeks, months, or even years), you might instead decide to hypothecate one of your existing assets. You can use stocks, expensive vehicles, or even another property you already own in your portfolio.
The lender agrees, so you and the lender enter into a promissory note. A mortgage is drawn up for the rental property. It includes a hypothecation agreement that notes the extra collateral you have pledged to the mortgage.
In this way, you, the borrower, can get the loan for your new rental property and add another feather to your cap. Meanwhile, the lender benefits because they now have equity in case you default on the loan. However, because this is a hypothecation agreement, you keep ownership of your asset.
You only risk losing ownership of the asset if you default on the mortgage. Everybody wins, making this a very flexible and useful real estate financing tool.
Pros of Hypothecation in Real Estate
There are several benefits to using hypothecation in real estate, including:
Hypothecated mortgages’ down payments are typically lower than the down payments for other mortgage agreements. Because of this, such loans may be more accessible to new or low net worth real estate investors.
The borrower retains the title for any hypothecated asset(s). Again, you don’t need to worry about losing ownership of your collateralized property or assets unless you default on the loan.
A hypothecation agreement provides extra security for lenders, making them more generous with their loans, amounts, or terms. This is doubly true for commercial mortgages, which are inherently riskier in many ways than residential mortgages.
Cons of Hypothecation in Real Estate
While hypothecation can be effective, it also comes with some risks you should be aware of before entering into one of these agreements yourself.
The biggest potential downside is that the lender can seize a borrower’s collateralized asset if they default on the loan. Thus, you should always consider the risks of defaulting on a mortgage loan before entering into a hypothecation agreement.
Furthermore, hypothecation agreements may lead to costly and long-term legal action. All borrowers must be aware that lenders can still pursue future legal actions, such as lawsuits, to secure the entire loan amount if the seized and sold-off asset doesn’t cover the full amount.
A loan for a hypothecated asset with a lower than average down payment may also come with a longer term or lifespan. Thus, borrowers should keep in mind that they might pay off such a loan over a longer period than they would normally, making them pay more in interest (however, hypothecated mortgage loans may also have lower than average interest rates – it all depends).
What is the Difference Between Hypothecation & Mortgage?
Real estate hypothecation and real estate mortgages are two different financing instruments, and it’s important to understand the differences between them fully before you choose between one or the other.
A mortgage, for example, is usually taken out for a huge amount of money, like several hundred thousand dollars. Hypothecation, on the other hand, is usually only leveraged to cover whatever a borrower can’t pay out-of-pocket, like the difference between a proposed down payment and the down payment demanded by a lender for a new property purchase.
Mortgages are used for immovable properties. The contract is drawn up for buildings, land, and so on. In contrast, hypothecation is used for immovable properties or assets like cars, stocks, or vehicles (though you can technically use other properties for hypothecation in real estate as well).
With a mortgage contract, asset interest is transferred to the lender first. Once the amount for the mortgage is paid off, the interest is re-transferred to the borrower. With hypothecation, asset interest is never transferred. Instead, when the borrower cannot pay the amount due based on the contract, the movable property is seized through foreclosure and sold off to get the proceeds to pay for the owed funds.
With a mortgage, mortgage deeds are required as the deal’s legally binding documents. With real estate hypothecation, hypothecation deeds are required instead, even if the contract is about a mortgaged property.
Lastly, mortgage tenure is usually much longer because of the above-mentioned larger loan amounts. With hypothecation, tenure is generally lower since the amount of the hypothecated note is lower.
In the end, hypothecation is a very useful tool for real estate investors who need to acquire financing for a new property to further their portfolio goals. Hypothecation in real estate might allow you to purchase a property that you would not be able to afford a down payment for otherwise. It may let you secure financing with more favorable terms, like a lower interest rate.
That said, be aware of the potential risks of hypothecation, namely the possibility that a lender may seize a collateralized asset if you fail to pay back a loan on time. In most cases, it’s only wise to use hypothecation if you are confident in your ability to pay back a loan on its original terms and if your collateralized asset(s) are worth enough to make the contract worthwhile.
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