As you advance your career as a real estate investor, you'll likely start to utilize creative investment strategies for acquiring, financing, or selling assets in your portfolio. One strategy in particular that can be used when trying to finance property is real estate hypothecation.
Hypothecation real estate is fairly common in the commercial real estate world, but this tool could be a useful way to leverage assets in your portfolio and obtain a more favorable loan or mortgage for a different piece of residential real estate.
If you're unfamiliar with the term hypothecation, continue reading to find out what hypothecation real estate is, how it works, when it's used in real estate investing, and the pros and cons of this financing strategy.
What is hypothecation?
Real estate hypothecation is when a borrower pledges a piece of collateral, such as a rental property, home, or movable asset like a car, boat, or stocks, to obtain a loan. The borrower pledges this asset to the lender as additional collateral in the event they aren't able to repay the mortgage and promissory note.
Hypothecation does not transfer any ownership rights of the asset from the borrower to the lender, nor does it give the lender the right to collect potential income from the property or asset, such as rent. Rather, it places a lien against the pledged collateral, which allows the lender to seize the property or asset through foreclosure if the borrower defaults.
How is real estate hypothecation used?
It's very common for commercial lenders to require additional collateral to be pledged or hypothecated when underwriting a commercial mortgage. These could be another investment property or your primary residence.
In residential real estate, hypothecation is most frequently used when a borrower is trying to get a loan from a bank and the lender is uncomfortable with certain aspects of the loan, which could include borrower qualifications or experience, loan-to-value ratio, the debt-to-income ratio of the borrower, or net worth, among other factors. Pledging additional collateral can help balance these ratios and make the loan more appealing for the financial institution to lend on.
Hypothecation may also be used when a property owner is requesting an unsecured loan or to help lower an interest rate to one more favorable. Lenders requesting to create a hypothecation loan are looking for assets that have equitable title, meaning you can hypothecate a property or asset even if there is an outstanding mortgage or debt as long as there is a certain amount of equity.
How does hypothecation work?
Let's say a borrower wants to get a loan to buy a rental property. They have $25,000 to use as a down payment, but the lender wants $30,000 down in order to write the mortgage. Rather than coming up with the additional $5,000 in cash, the borrower can hypothecate an additional asset, such as stocks or a car.
The lender (mortgagee) and the borrower (mortgagor) enter into a promissory note and mortgage for the rental property with a hypothecation agreement that includes the additional collateral. The borrower is able to get the loan for the new rental property, and the mortgagee now has equitable interest in a property in the event the borrower defaults. The mortgagor keeps ownership to the asset that was hypothecated, only risking losing their equitable title if they default on the rental property mortgage.
Pros and cons of using hypothecation in real estate
Hypothecation can be a useful strategy to help improve terms for financing or get approved for a loan at all, but it does mean you're risking losing the pledged collateral. If a hypothecation loan is on the table when you're looking for financing, make sure you're comfortable with this possibility. While no one wants to enter a hypothecation agreement expecting or hoping to lose their pledged assets, it is a possible outcome. For this reason, it's a good idea to only hypothecate assets you'd be willing to lose.