A Brief Introduction About the Hypothecation Agreement
What is a hypothecation agreement? A hypothecation agreement is an agreement between a borrower and the lender where the ownership of the asset is with the borrower.
What is hypothecation? Hypothecation is a collateralizing agreement where only the right to sell an asset is transferred to the lender. The possession and title remain with the borrower.
The borrower pledges the asset to the lender as collateral against a loan. The lender does not take possession of the asset as per the hypothecation definition.
When it comes to hypothecation in real estates, like any other hypothecation agreement, the ownership of the asset is not transferred to the lender. The lender can, however, sell the asset in the event the borrower does not service the debt within the period stipulated in the agreement. The borrower can pledge the property as collateral for servicing the mortgage or can hypothecate the mortgage to obtain a loan against the market value of the property.
Who Takes the Hypothecation Agreement – People Involved
A hypothecation agreement is an agreement is taken by the borrower and lender, where the lender agrees to extend a loan to the borrower against an asset which is hypothecated to the lender. There is no transfer of assets in such cases, the ownership of the asset remains with the borrower. The lender, however, gets possession of the property in the event the borrower defaults in repayment of the loan obligation.
Borrowers prefer to hypothecate the asset ownership to remain with them. Lenders charge lower interest rates on hypothecation as they have collateral, and they can sell the collateral if the borrower defaults. The loans under hypothecation are not as large as mortgage loans and are preferred by buyers to tide over a short period of the liquidity crisis.
Purpose of the Hypothecation Agreement – Why Do You Need It?
What is hypothecation? Hypothecation is a legal contract where the owner of an asset and borrower transfers the right to sell the asset to the lender, but not the title to the property. The loans are smaller compared to mortgage loans. The lender, however, may sell the asset in the event the buyer defaults in discharging his or her debt obligations.
The purpose of a hypothecation agreement is to protect the interest of the borrower and the lender. The borrower and lender enter into a hypothecation arrangement on mutually agreed terms. The agreement ensures that the debt obligation of the borrower is discharged on time with respect to the principal and the interest, and the borrower is able to get the required loan in time.
The hypothecation agreement will have all the details of the asset being hypothecated and the estimated market value of the asset on the basis of which the loan is being extended. It will also have the required information with regard to interest being charged on loan as well as the repayment schedule. The lender knows that the loan extended is safe and that the possession of the asset is transferred to them in the event the buyer defaults. The borrower is aware of the terms and conditions of the loan and will try to ensure repayment in the stipulated time so as to avoid losing possession of the asset.
Contents of the Hypothecation Agreement – Inclusions
A hypothecation agreement is a legal contract between the borrower and lender, where the lender offers a loan to the borrower on mutually agreed terms and conditions against the hypothecation of an asset owned by the borrower.
A hypothecation agreement must include the following:
- Parties to the agreement: The parties to the agreement, the borrower and the lender must be mentioned in the agreement
- Date of the agreement: The date from which the agreement is effective must be included in the agreement.
- The asset being hypothecated: The details of the asset being hypothecated needs to be incorporated in the agreement
- Duration of the loan: The period for which the loan is being extended needs to be mentioned in the agreement
- Interest on the loan: The interest being charged needs to be stated
- Repayment schedule: The borrower’s repayment schedule needs to be clearly stated in the agreement. The specific date and frequency of payment need mention in particular.
- Penalties: The penalty payable by the borrower in case of delayed payment and the consequences of default need to be mentioned. The penal interest needs to be stated. The events which lead to violation of the terms of the agreement and possession of asset by the lender must be incorporated
- Applicable laws: The agreement must be made in accordance with the applicable laws of the state
- Termination of contract: The contract stands terminated if any clause has been breached by either the borrower or lender with regard to the laws of the state
- Application of proceeds: The agreement needs to clearly state how the application of sale proceeds of the asset will be utilized.
How to Draft the Hypothecation Agreement?
Points to consider while preparing the agreement
While drafting a hypothecation agreement, it is important to keep the following points in mind:
- Parties involved: The agreement must contain the names of the parties involved as well as the relationship shared between them
- The asset being hypothecated: The asset which is being hypothecated by the borrower to the lender should be mentioned including its estimated value
- Loan details: The loan being extended will be calculated as a certain percentage of the asset that is hypothecated. The details must be mentioned.
- Period of the loan: The period of the loan must be incorporated
- Interest payable: The method by which the interest is calculated, and the component in the monthly installments needs to be mentioned
- Frequency of payment: The frequency of payment of the monthly installments must be stated, whether they are monthly and quarterly. The circumstances under which the due date could be extended should be entered into the agreement after mutual consent of both parties
- Governing law: The terms and conditions of the agreement are bound by the laws of the state applicable to hypothecation
- Amendment to the agreement: There should be a clause specifically stating how the agreement can be amended after mutual agreement by both parties
- No waiver: The lender may, if required, take possession of any other asset owned by the borrower to meet the loan obligation
Negotiation Strategy
In a hypothecation agreement, it is important for the lender to verify the asset and accordingly decide the amount of loan they will extend to the borrower. The borrower should negotiate the amount of loan against the asset being hypothecated, the interest rate, the frequency of repayment before signing the agreement.
Benefits & Drawbacks of the Hypothecation Agreement
The benefits of having a hypothecation agreement are:
- Protection of interest of both parties: The interest of both the lender and the borrower is protected through the agreement. The lender has been assured timely repayment of both interest and principal, and the borrower gets the loan as and when required.
- Security for the lender: As the borrower has to provide the lender with collateral against which the loan is being taken, the lender knows that in the event of default the asset can be sold to realize the loan amount
- Lower interest rates: As the loan is provided against the asset, the interest rates are lower, and this is beneficial for the borrower
- Smaller loans: These loans are smaller compared to mortgage loans, and borrowers take these loans for a short term to tide over any liquidity problems
The drawbacks of having a hypothecation agreement are:
- Losing the asset: While the title of the asset remains with the borrower in case of hypothecation, in the event of default, the ownership and the right to sell are transferred to the lender. The borrower loses the asset in such cases
- Inadequate asset value: The value of the asset might not be adequate for realizing the loan obligation in case of default. The lender needs to take possession of another asset owned by the borrower, which would make up for the shortfall. The borrower may not have such assets
What Happens in Case of Violation?
A hypothecation agreement is an agreement which is made in accordance with the laws of the state to protect the interest of the borrower and lender. Every clause of the agreement has to be drafted as per the requirement of the laws of the state.
The lender needs a hypothecation agreement in order to secure the loan provided by them. The agreement ensures that the principal and interest on the loan is repaid to the lender on time, failing which the lender can sell the asset to realize the loan obligation.
The borrower is aware of the fact that the title to the asset remains with him or her, provided that the payment is made in accordance with the loan repayment schedule.
If there is a violation of the contract by both parties, then the agreement stands null and void(1).
If the borrower violates the repayment clause of the agreement, then the lender has the right to sell the asset provided as collateral by the buyer to realize the loan value.
The default events are clearly mentioned in the agreement and include failure to repay the loan, if any part of the collateral is seized under any attachment or legal process or if the warranty furnished by the borrower proves to be false.
The borrower needs to keep these events in mind so that there is no violation.
A hypothecation agreement is an agreement which is required when you want a loan. The lender will need some kind of security from you against the loan so that there is no default of the principal and interest payable on the loan. The loan will be extended after the asset has been verified with regard to value and a clear title.
As the borrower, you need to find out which lender gives you the best terms as far as the loan amount, interest rate, and repayment period is concerned. The title to the asset remains with you under this agreement so long as there is no default on your part with regard to the repayment of your dues. It is, therefore, very important for you to read the terms and conditions of the contract before signing it.
A hypothecation agreement is beneficial for both the borrower and lender provided none of them violate any hypothecation clause.