Hypothecation of a note means borrowing money and pledging a note you own as the collateral. You go on owning the note while the lender holds it as security, and if you fail to repay the loan the lender can take it.
Two loans, one on top of the other
The first is the underlying note, the one you already hold: a borrower owes you money, secured by a property. The second is the new loan. A lender advances you cash, you sign your own promissory note to that lender, and you pledge the underlying note as collateral for it.
The payments from the underlying note keep coming. You use them, or other money, to make the payments on your new loan. When your loan is paid off, the pledge is released and you hold the note free and clear again.
What gets signed
- A loan agreement and promissory note from you to the lender, setting the amount, rate and term.
- A collateral assignment of the underlying note and its mortgage or deed of trust. It is given as security and stops short of an outright transfer, and the lender will want it recorded.
- Delivery of the original note to the lender or a custodian, so you cannot sell or pledge it to anyone else.
- Payment instructions. A lender may require a servicer to collect the underlying payments, pay the lender first and send you the rest.
Terms differ from lender to lender. Read what counts as a default on your loan and what the lender may do with the note if one happens.
What a lender looks at
The lender is judging two borrowers. It looks at the underlying note the way a note buyer would, with the checks in the investor guide: the payer’s history, the equity in the property, the lien position and the paperwork. Then it looks at you, at your credit and at your ability to keep paying if the underlying payments stop.
Expect the advance to be smaller than the price a buyer would pay for the note outright. The lender wants a margin between the loan and the note’s value in case it ever has to take the note over.
Hypothecation compared with selling a partial
The nearest alternative is a partial sale, where you sell a set number of future payments for a lump sum and the note returns to you afterwards.
| Hypothecation | Partial sale | |
|---|---|---|
| What it is | A loan to you | A sale of payments |
| Do you owe anything? | Yes, whatever the payer does | Depends on the agreement. A sale creates no loan to repay |
| Who carries payer default | You, in full | Set by the partial agreement |
| Your credit matters | Yes | Generally much less |
| How it ends | You repay the loan | The buyer collects its payments and reassigns the note |
For a fuller comparison from the note holder’s side, see partial sale vs borrowing against my note. A loan and a sale are also generally treated differently for tax, so ask a CPA before you choose on that basis.
The risks to weigh
- You owe the loan even if the payer stops. If the underlying payments dry up, your loan payment is still due.
- You can lose the whole note. Depending on the loan terms, a default on a small loan can cost you a note worth far more than the amount borrowed.
- An early payoff unwinds it. If the payer refinances or sells, the lender is repaid from the payoff first. Check whether your loan charges a fee for that.
- Two rates. If your loan costs more than the underlying note earns, borrowing against it loses money each month. That may still be worth it for a short-term need, so long as you have worked out the monthly figure.
Where a note buyer runs into it
Some investors borrow against notes they own to raise cash for the next purchase without selling. Borrowing enlarges the possible loss along with the possible gain, which makes it a tool for someone who has already owned notes through a default.
The more common meeting is on the other side of a purchase: the note you are about to buy may already be pledged. A recorded collateral assignment should appear in a title search such as an ownership and encumbrance report, and a seller who cannot produce the original note from the collateral file may have delivered it to a lender. For any note we send once you join the buyer list, ask where the original is held before you bid.
Before you fund a note that was pledged
Get the lender’s written payoff figure and its release of the collateral assignment, and have both handled through the closing so the lender is paid and the pledge is lifted at the same moment you take ownership. Afterwards, confirm that the release was recorded and that the original note reached you or your custodian.
Related questions
Is hypothecating a note the same as selling it?
No. In a sale, ownership passes to the buyer. In hypothecation you still own the note and have taken on a debt of your own, with the note pledged as security. If you repay the loan, the pledge is released.
Does the payer on my note know it has been pledged?
If the lender requires a servicer to collect the payments, the payer is told where to send them. Their rate, payment and payoff date do not change. Whether any notice is required depends on the loan documents and state law.
How do I find out if a note I am buying is already pledged?
Look for a recorded collateral assignment in a title search, ask where the original note is held, and have the seller state in the sale agreement that the note is not pledged. If a lender is involved, get its written payoff and release at closing.