Real estate investors use a wide range of strategies for financing, acquiring, or selling assets. One little-known strategy that you can use to finance investment property is real estate hypothecation. While this strategy is commonly used in commercial real estate, hypothecation in real estate also be a great way to leverage your assets and acquire a loan for residential real estate.
What does hypothecate mean? How does hypothecation in real estate work? What are its pros and cons? What does a hypothecation agreement entail? These questions will be answered in this article.
Related: A Guide to Creative Financing for Real Estate Investors
What Is Hypothecation in Real Estate?
Hypothecation in real estate happens when a borrower pledges some kind of collateral, such as a primary residence or rental home to get a loan. In other words, the borrower pledges this asset as extra collateral in case they fail to repay the mortgage. However, this doesn’t involve transferring ownership rights from the borrower to the lender. The lender is also not allowed to collect income from the asset or property, such as rent. Rather, hypothecation places a lien against the pledged asset, which permits the lender to seize the collateral in case the borrower defaults.
Commercial lenders often require extra collateral to be hypothecated or pledged when underwriting a commercial loan. This could be your primary residence or another income property.
When it comes to residential real estate, hypothecation in real estate is commonly used when a borrower wants to get a mortgage from a bank, but the lender is not comfortable with aspects such as the debt-to-income ratio of the borrower, loan-to-value ratio, borrower qualifications, or net worth. In such a case, pledging extra collateral makes the mortgage more appealing for financial institutions.
Hypothecation in real estate might also be applied when a home buyer is asking for an unsecured loan. Lenders are often willing to offer hypothecation loans against assets that have an equitable title. This means that you can hypothecate a property even if it has an outstanding loan, as long as there’s sufficient equity.
How Hypothecation in Real Estate Works
Let’s say you want to obtain a loan to purchase a rental property. You have $30,000 to use as a down payment, but the lender is asking for $40,000 down to process the mortgage. Instead of raising the extra $10,000 in cash, you could hypothecate an asset like a car or home.
The borrower (mortgagor) and the lender (mortgagee) enter into a mortgage and promissory note for the home with a hypothecation deal that includes the additional collateral. The mortgagor can now get a loan and the lender has an equitable interest in the collateral in case the borrower defaults.
Hypothecation vs Rehypothecation
Rehypothecation is basically the hypothecation of an asset that is already hypothecated. In other words, it is when a lender takes assets that have been posted as collateral by their customers and uses them as collateral for new debt. In the United States, SEC Rule 15c3-3 and Federal Reserve Regulation T allow the rehypothecation of collaterals posted by customers. Customers who allow rehypothecation of their collateral might be rewarded through a rebate on fees or a lower cost of borrowing.
Benefits of Hypothecation in Real Estate
- Retains possession and ownership: When it comes to hypothecation, possession, and ownership of the collateral remain with the borrower. There is no possession transfer, ownership transfer, or title transfer. However, the lender is allowed to seize the collateral if the borrower defaults or violates the terms and conditions of the lender
- Lower interest rates: When the borrower offers collateral for a mortgage, the loan becomes cheaper. The interest rate on secured loans is usually much lower than the rate on unsecured loans
- Availability: Since hypothecation loans are secure, there is a lot of competition among lenders offering such loans. As a result, hypothecation loans are readily available
Downsides of Hypothecation in Real Estate
- Loss of collateral: As mentioned earlier, defaulting on a hypothecation loan or failing to comply with the terms and conditions will mean losing your asset to the lender
- Legal suits: If the lender is unable to recover the unpaid loan even after selling the collateral asset, they can take the borrower to court. This could result in imprisonment or hefty fines for the borrower
- Poor credit rating: If the borrower fails to adhere to the terms and conditions of the mortgage agreement, their credit score will be negatively affected. This will make it difficult for the borrowers to qualify for loans in future
Important Clauses of a Hypothecation Deed
A hypothecation deed is legal paperwork that outlines the contractual relations between the borrower and the lender. The deed defines all the liabilities and rights of the parties which can be administered in a court of law.
Before signing a hypothecation deed, you need to have a good grasp of all the important clauses in such an agreement. Be sure to read through the entire document while paying careful attention to each hypothecation clause.
Here are some of the vital clauses of a hypothecation deed:
Obligations of the Parties
This clause explains the liabilities and rights of both the lender and borrower in regards to the loan amount given and the asset offered as collateral against the loan. The clause could cover the mode of loan disbursement, the number of installments, and the fulfillment of specific conditions before disbursement.
This clause points out in detail what kind of security is provided as collateral against the loan advanced. The properties used as collateral are referred to as secured properties or hypothecated properties. The clause also mentions the maintenance costs, insurance charges and repairs to be borne by the borrower.
Title and Ownership
This clause makes it clear that the borrower retains the ownership and title of hypothecated assets as well as the earnings generated from them. The clause also mentions that the lender shall be allowed to seize the collateral when there is a default in payment or a violation of any other condition outlined in the agreement.
Interest and Default Interest Rate
This clause mentions the applicable interest rate to be paid on the loan until the borrower completes repayment. It also states the default interest rate payable by the borrower in event of default in repayment.
Repayment of Hypothecation in Real Estate Loan
In this clause, the parties agree on the duration within which the debt must be repaid along with interest. The clause also states the manner and mode in which repayment is to be done. It could also make a provision for extension of the repayment period, subject to the agreement of both parties.
This clause explains how the lender will recover the unpaid loan in case the borrower is declared insolvent by a court of law. The clause might also emphasize the right of the lender to possess the hypothecated asset to recover the unpaid loan.
Representations and Warranties
This clause states all the assurances and assertions offered by the lender and borrower under the agreement. The clause also states that the parties involved agree to offer all the necessary and required help to each other to fulfill their respective duties and obligations with due diligence.
Hypothecation in real estate can be a very effective strategy for raising funds for buying an investment property. While hypothecation in real estate has several advantages, it is also very risky. Therefore, be sure to mind your due diligence before you hypothecate real estate.
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