Hypothecation, Mortgage & Pledge in a Business Loan Explained - Tata Capital

Hypothecation, Mortgage & Pledge in a Business Loan Explained

Feb 07, 2017

Many businesses often shut down due to the lack of funds. However, finance should not be a problem anymore, owing to the limitless funding options available. Besides, financiers also offer numerous benefits to loan seekers, such as extended loan tenure and lower rates of interest. Some financiers also offer flexible repayment options wherein businesses may repay the loan amount as per their cash flow.

There are two basic types of loans, secured and unsecured loans. This classification is done on the basis of security pledged against the loan. Unsecured business loans are not protected by any collateral. If you default on your loan repayments, the lender does not have the right to automatically seize the collateral. Secured loans, on the other hand, require collateral to be kept against the loan. In the case of non-payment of installments, the financier may take ownership of the collateral. This collateral may either be immovable assets like land and property or movable assets like vehicle or gold. Based on the nature of the collateral pledged, secured loans may be divided into the mortgage, hypothecation, and pledge.

Mortgage

A mortgage is a secured debt instrument, wherein the borrower is obliged to keep collateral in return for a loan. Generally, immovable possession, such as a house or land, is kept as a mortgage against loans. The financiers have the title of ownership of the asset until the borrowed amount is repaid in full. Upon complete payment of the Equated Monthly Installments (EMIs), the ownership of the asset is transferred back to the borrower.

Hypothecation

Hypothecation is slightly different from a mortgage. In hypothecation, the borrower provides collateral such as property, vehicles, stocks or shares but continues to retain total ownership. Entrepreneurs may, therefore, avail of a loan without worrying about losing ownership of the asset. Since this practice provides security to the lender due to the collateral provided by the borrower, the financier offers a lower rate of interest as compared to an unsecured loan. Hypothecation, therefore, helps the borrower to obtain a business loan on favorable terms. However, the borrower faces the risk of losing the asset if the EMIs of the loan are not paid on time.

Pledge

Borrowers may also keep immovable assets such as gold, advances against goods, advances from National Savings Certificate (NSC), and others as security against the loan. This practice is known as pledging, wherein the lender (pledgee) takes actual possession of the assets. In case the borrower defaults on payments, the lender has the right to sell the collateral and recover the unpaid amount.

The three aforementioned terms differ from each other with respect to the nature of the asset. Borrowers may keep movable assets like gold, vehicles, or any other as collateral against the business loan in case of a pledge or hypothecation. However, only immovable property like land or building may be kept as security in case of a mortgage. It is important for entrepreneurs to choose the collateral to be kept against the loan, based on the type of asset that is owned by the business.