A hypothecation agreement is a contract between a debtor and a lender in which the debtor pledges some type of asset as collateral on a loan, without actually delivering that collateral to the lender. Often, the agreement provides for the establishment of a lien on the asset until the loan is paid in full. A mortgages in which the purchased property is utilized as the collateral are one of the most common examples of a hypothecation agreement. The term is also used to describe the contract that governs the establishment of a margin account with a broker. In this particular scenario, the hypothecation agreement is often known as a margin agreement.
In each of these two scenarios, the hypothecation agreement helps to reduce the risk taken on by the lender. This in turn increases the chances that the lender will choose to do business with the debtor, since the potential to benefit from extending the loan or the line of credit on the margin account is greater. At the same time, the debtor is able to enjoy use of the pledged asset even as the obligation to the debtor is honored.
The type of collateral that is utilized often depends on the situation in which the hypothecation agreement is established. For example, if the contract is related to the purchase of real estate, the debtor pledges the acquired property to support the loan. In some cases, the lender may accept a different piece of property that is currently clear of any liens or other obligations as the collateral for the mortgage loan. Should the debtor fail to make timely payments and ultimately default on the mortgage, the terms of the hypothecation agreement allow the lender to seize control of the pledged real estate and sell it in order to retire all or at least a portion of the outstanding debt. It is important to note that if the subsequent sale of the property does not generate enough revenue to cover the outstanding balance on the debtor’s account, the lender is often free to take additional legal action to recover the rest, possibly by garnishing the wages of the debtor.
In like manner, a hypothecation agreement associated with a margin account also requires pledging assets that the broker may claim in the event the investor does not pay back funds borrowed on margin according to terms. Typically, the assets pledged are specifically identified securities that are held in the investor’s account, with the number of shares pledged also identified as part of the terms and conditions of the contract. Should the investor be unable to repay the amount borrowed on margin for any reason, the broker has the right to claim ownership of those pledged securities to settle the debt. Should the current market value of those pledged assets not cover the total amount of the margin amount due, the broker may have the right to not allow the investor to buy on margin again until that remaining balance is settled. This may be managed by either willingly selling other securities to the broker, or providing a cash payment that retires the balance due in full.