What is Hypothecation?
The term “hypothecation” refers to the process wherein the lender is offered a moveable asset as collateral security against the loan. In other words, hypothecation is a type of collateralized loan that is primarily used to fund purchase of moveable assets, such as motor vehicles. In case the borrower fails to service the debt obligation, then the lender has the right to take ownership of the hypothecated asset. In the US, the lender’s legal right to take ownership of the collateral is known as a lien.
Explanation of Hypothecation
As already mentioned in the previous section, hypothecation is a type of collateralized debt offered by the lender. Hypothecation is done in case of moveable assets to create the charge against collateral for the given loan. However, in this type of loan although the right to ownership lies with the lender,but the possession of the collateralized asset remains with the borrower. In case the borrower defaults on the loan, then the lender can legally exercise its ownership rights and seize the collateral to recover the outstanding dues, which include both principal and interest amount.
Example of Hypothecation
For example, suppose David requires a loan to purchase a new car. Now, if he doesn’t have any collateral (unsecured loan) then the interest rate could be very high to compensate the risk of non-recovery in case of a default.On the other hand, if he agrees to the hypothecation arrangement and offers the new car as the collateral security, then the interest rate charged could be significantly low depending on the terms & conditions of the lender. In this scenario, if David is unable to pay the bank dues within the given time, then the bank will seize the new car to recover the dues.
How to Remove Hypothecation in Case of Insurance?
It is important to remove the hypothecation in case of insurance or otherwise the claimed insurance benefit will go to the lender instead of the owner. In fact, even if the registration of the vehicle is clearly in the name of the owner, the hypothecation reference still needs to be removed for insurance purposes. Now, let us look at the step by step process for removal of hypothecation in case of insurance.
- Collect the No Objection Certificate (NOC) from the lender or the bank stating that the car loan has been closed.
- Visit the office of the local transport authority and provide a copy of the NOC received from the bank. The applicant will be asked to visit another specified date.
- Another copy of the NOC has to submitted to the insurance company.
- Submit the application form for removal of hypothecation.
- Visit the office of the local transport authority once more on the specified date and collect the ‘Acceptance Form’ from the officer who had verified the applicant’s documents. The ‘Acceptance Form’ contains all the details mentioned on the registration certificate.
- Finally, after all the steps have been completed successfully, the applicant will get rightful ownership of the vehicle and the lender’s ownership of the vehicle will be cancelled.
The hypothecation agreement between the lender and the borrower is done through a document that is known as the hypothecation deed. Typically, a hypothecation agreement includes definitions, insurance details, rights & remedies for each party, inspection rules, details of the security that has been marked for hypothecation, each party’s liability, sale realizations, relevant jurisdiction, etc. In effect, this agreement intends to protect the rights of both – lender and borrower.
In case the buyers purchase a car with their own available fund, then they need not pay any hypothecation charges. These charges are paid by the purchaser when they opt for a loan to purchase the car. The hypothecation charges can vary depending on the type of asset being purchased.
Some of the major advantages of hypothecation are as follows:
- The ownership and possession of the asset remain with the borrower in case of hypothecation, which means that the borrower has access to the asset all the time.
- Since the loan is backed by collateral, it is considered to be secure by most lenders. As such, more and more lenders are ready to fund such loans, which results in higher competition among lenders and hence lower interest rates for the borrower.
- Hypothecation is usually done for a small number of loans, which makes it easierto use and payoff.
Some of the major disadvantages of hypothecation are as follows:
- Even if the borrower has partly paid off the installment, the lender has the right to seize the collateral in case of any delay in payment. This can result in a significant financial loss for the borrower.
- The borrower is exposed to the risk of legal consequences from the lender if the sale of the seized asset is unable to cover all the outstanding dues.
So, it can be seen that borrowers can use the hypothecation route to raise funds to purchase the movable asset and continue to use the asset even during the currency of the loan. Given that the loans are collateral backed, they attract lower interest rates as compared to unsecured loans. Even these loans are preferred by the lenders because of the available collateral. However, the lender should periodically check and keep track of the availability of the collateral to safeguard their interest.
This is a guide to Hypothecation. Here we also discuss the introduction and how to remove hypothecation in case of insurance? along with advantages and disadvantages. You may also have a look at the following articles to learn more –