Advantages & Disadvantages of Hypothecation

Hypothecation Meaning

Hypothecation means pledging of the asset as collateral to the lender in exchange of loan. It is a very secure loan from lender’s perspective as the lender has right to possess & sell the asset, in case of default. There are some advantages & disadvantages of hypothecation.

No title transfer, possession or ownership transfer takes place in hypothecation. However, the lender can seize the asset & sell it, if the terms of the agreements are not met.

For Example, you buy a car on loan. You pledge car as collateral to the bank. Now you know you are the owner of the car & you use it & possess it. No title transfer, possession or ownership transfer takes place.

Advantages & Disadvantages of Hypothecation

Advantages of Hypothecation

i) Retains Ownership & Possession

Unlike pledging & mortgage, ownership & possession remains with the borrower in hypothecation. No title transfer, ownership transfer or possession transfer takes place. However, the lender has right to possess & sell the asset, in case of default by borrower or violation of terms of hypothecation agreement.

ii) Lower Interest Rate

As the lender has an asset as collateral, the loan is considered more secure. Consequently, more lenders are available for such a loan. Due to high competition between lenders, interest on such loan is lower compared to an unsecured loan.

iii) Small Loans

Unlike a mortgage, this is done for a small number of loans. As result, it is easy to use & payoff. Generally, hypothecation is done for small loans like a car loan, home appliance loans.

iv) Easy Availability

This is a major benefit of hypothecation. A loan is secured by asset and therefore there is cut-throat competition in the market. We know the competition is beneficial for customers, more the suppliers, easy the availability.

Disadvantages of Hypothecation

i) Seizure

If the borrower is not able to pay installments/EMI, then the lender has right to seize the asset & sell it. The lender may also seize asset if terms & conditions of hypothecation are not met. Suppose, the borrower has paid all installments except last 3 or 4, then also lender may seize the asset.

ii) Legal Action

The lender may take legal action if the lender is not able to recover all dues even after selling the seized asset. Therefore the borrower has to face legal consequences, which may include penalty or imprisonment

iii) Compliance

The borrower has to comply with the terms & conditions from time to time. e.g. submitting stock statements every month while taking cash credit. If you fail to comply, you will be liable for a penalty. This may become a headache for the borrower.

iv) Credit Rating

If you default in repayment of a loan, it may affect your credit rating score. If your credit rating score is low, then further borrowing may become difficult for you.

v) Unnecessary Buying

As the loans are available easily at a lower interest rate, you may buy the asset even if it is not necessary for you.

vi) Increases Cost

The borrower makes payment in installments. Installments include interest which increases the price of the asset. Generally, the cash price is lower than asset bought on installments.1,2

1.
Kenton W. Hypothecation. Investopedia. January 2019. [Source]
2.
Hypothecation | Definition | What is Hypothecation Agreement? WallStreetMojo. January 2019. [Source]
Last updated on : January 22nd, 2019

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