Hypothecation describes the practice of a borrower of debt pledging an asset (like a house) as collateral in order to obtain a loan from a lender, with the borrower retaining possession and control of the asset.

While this term can be used to describe various business practices, it is most well-known in the real estate industry in how mortgages work.

A home buyer basically uses the property as a security for a secured loan to obtain a home loan approval from a lender.

The lender or creditor will then have the legal right to foreclose the house should the borrower default on the mortgage.

A big reason why hypothecation might be necessary is often due to the borrower requesting a huge amount of credit.

And in order to mitigate risks, the lender needs collateral to minimize their exposure should the borrower fail to repay.

Another common form of hypothecation is with auto loans.

In this case, the vehicle owner pledges the car as collateral for the auto loan while retaining possession and full use of the vehicle.

Should the owner fail to repay, the car might be towed away right from his driveway.