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Definition - What does Hypothecation mean?

Hypothecation is the process by which a borrower pledges an asset as a collateral in order to obtain a loan, without forgoing the ownership rights to that asset. As a result, the borrower gets to enjoy the benefits or income that is generated by that asset. However, the lender has the right to seize the asset if the borrower cannot repay the loan according to the stipulated terms and conditions entered into by both the parties at the time of signing the loan agreement. For the purpose of hypothecation, assets can also includes the securities of a company. These securities can be used as a collateral to borrow funds for the acquisition.

Divestopedia explains Hypothecation

Hypothecation offers many advantages to borrowers. Firstly, the borrower retains ownership to the asset, and can enjoy the income that comes from it. Secondly, hypothecation is a form of secure loan because the asset acts as collateral. Hence, the interest rate is likely to be much lower than an unsecured loan. However, the borrower will lose the asset if prices plunge or if the loan cannot be serviced for any reason. For the lender too, hypothecation is an advantage because there is an asset to fall back on, if the borrower defaults on payment.

There are many kinds of hypothecation; mortgages and margin loans are the most common but can also be negotiated in the purchase of a business. A firm that lends money to an investor to purchase securities of a company can take back or hypothecate the securities if the investor fails to repay the loan according to agreed terms and conditions.

Sometimes if vendor financing is used to fund an acquisition, the vendor will try to negotiation the hypothecation of the stock in the company sold, If the acquirer cannot fulfill the obligations under the vendor financing agreement, the vendor will be able to take back the shares.

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