Hypothecation in Banking | Meaning, Explained with Easy Example

Hypothecation is one of the modes of creating a charge on security to secure the debts/advances. So let us discuss the meaning and definition of Hypothecation in banking.

Whenever an individual or firms need a loan/debt from any banks or financial institution, he has to provide some security/assets against the secured debt/loan. There are mainly two types of securities/ assets (Movable or Non-movable properties) which can be pledged to acquire a loan from any financial companies or banks.

Further, the bank or financial institution creates a charge over the assets/property before approving the loans. Thus the procedure of creating the charge on securities can be done through various methods depending on types of securities and loans.

Hypothecation in Banking:

“Hypothecation refers to the practices of creating a charge on movable assets/properties of the borrower, however, the possession of property retains with borrower itself.”

In other words, Hypothecation is the process through which the banks/lender pledge the properties of the borrower to secure the loans. Here the possession and ownership of property/ assets remain with the borrower but if the borrower defaults the ownership of goods is transferred to the lender/banks. 

Moreover, if the borrower defaults or unable to repay the debt, the lender has the rights to seize and sellout (auction) the property to compensate or recover the debt/loan.

Some important points to remember about hypothecation are as follows.

  • The concept of hypothecation is defined in Section 2 of SARFAESI ACT 2002.
  • Hypothecation is also created on movable properties only like pledge.
  • Neither ownership nor possession of the movable properties/goods is transferred to the banks or financial institutions.
  • In the case of hypothecation, the charge created is the equitable charge.
  • When any business firms/owner hypothecate its stocks/inventory to obtain a loan/debt (CC loan), then such hypothecation is a floating charge.
  • If the borrower defaults the loan, the lender will first seize and take possession of assets then he can go for auction to recover the debt.
  • The borrowers don’t have the rights to sell the hypothecated assets until the debt obligation is fulfilled.

Example of Hypothecation:

Let us consider a real-life example to better understand the concept of hypothecation.

1) Vehicle loans (Auto/bike Loans) are the best example to understand the hypothecation. If an individual wish to purchase a car and doesn’t have sufficient funds to buy hard cash. He will surely approach the bank to get the vehicle loan. The bank will hypothecate the vehicle which is to be purchased and approve the loan.

That means the bank will create a charge (hypothecation) over the car till the repayment of the loan. In this case, both possession, as well as the ownership, retain with the borrower. The borrower enjoys the benefits of property and gradually repay the loan to the bank or finance company.

Some other examples of hypothecation are CC loan (Cash Credit) against stocks or inventory.

2) Suppose Mr X is a drug distributor (wholesaler) require a loan of Rs 10,00,000/- to increase the supply of medicine. He approaches his bank and asks for a debt called CC Loan.

The bank doesn’t want to provide him with an unsecured loan that’s why Mr X was asked to pledge his existing inventory with the bank as a security. Bank doesn’t keep the stocks with itself, however, the inventory will be hypothecated. 

In this case, neither possession nor ownership of stocks is transferred to the lender/ banks.

Conclusion:

Hope you have understood the meaning and definition of hypothecation in banking. In a nutshell, hypothecation is a charge created on movable property of the borrower to secure the debt with no possession of actual assets/ properties.

The main advantage of hypothecation is that the borrower enjoys his property as well as loan for the shake of his interest.

Recommended Articles:

What is Pledge in Banking?

Difference between Pledge and Hypothecation

What is Bill Discounting?

What is Letter of Credit?

 

References: 1) Wikipedia, 2) Investopedia

 

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