Hypothecation (in the context of taking security)

The procedure of securing a loan against property. A letter of hypothecation is a document in which the drawer of a bill of exchange agrees that the property shall be sold and the money used to pay the amount owing if it is dishonoured.

A common example of hypothecation arises when a debtor enters into a mortgage agreement, and the debtor’s house becomes collateral until the mortgage is paid off in full. The debtor retains constructive ownership of the collateral, but the creditor has the right to seize ownership if the debtor is to default on the payments.

Hypothecation mitigates the risk for creditors, which may be passed on in the form of lower interest rates to the debtor. If the debtor cannot or does not pay, the creditor gains legal possession of the collateral and is able to sell it to maintain liquidity.

Rehypothecation occurs primarily in financial markets when financial firms re-use collateral to secure their own borrowing.