Debt deflation occurs when the value of an asset used as collateral for a loan decreases, causing lenders to adjust loan terms. Even assets believed to increase in value can fall victim to debt deflation. Regulations govern lender actions, and borrowers should understand what lenders can and cannot do in such situations.
Also known as collateral deflation or worse deflation, debt deflation is a situation where the value of the asset used as collateral for a loan decreases in value. When this occurs, the lender may find it necessary to adjust the terms and conditions of the loan in order to keep its degree of risk within an acceptable range. While lenders typically try to avoid accepting collateral that has some potential to lose value over the life of the loan, even assets that are believed to increase in value can fall victim to debt deflation under the right circumstances.
One way to understand the impact of debt deflation is to consider taking out a mortgage to buy a home. At the time of loan approval, the market value of the home is slightly more than the total amount owed on the mortgage. With this in mind, the lender is willing to accept the purchased property as collateral for the loan. In many situations, the property will increase in value over the years, or at least retain its initial value. As a result, the lender is safe, knowing that even if the homeowner defaults on the mortgage, the property can be sold and the outstanding balance on the loan recouped.
If that property depreciates rather than increases in value, the lender will compare the current market price the property can ask for with the outstanding balance on the mortgage. If the rate of debt deflation accelerates and eventually exceeds the value of the property, this places the lender in a high-risk situation, as the ability to sell the property and cover the mortgage balance no longer exists. At this point, the lender may attempt to renegotiate your mortgage as a means of minimizing risk, or even call the loan owed if the property is expected to continue to depreciate and the possibility of a default is imminent.
The actions a lender can take when debt deflation occurs will be governed by regulations put in place by government agencies that oversee the purchase of property within the borders of the nation where the mortgage is written. In some cases, the option to pay off the mortgage is limited, as the lender cannot pay off the mortgage owed until the property value falls below a certain amount, or the homeowner actually lacks a certain amount. number of consecutive payments on the loan. These kinds of checks and balances help minimize the opportunity for lenders to apply for mortgages based on short-term situations that cause the collateral to temporarily lose value that it eventually recovers once those situations are resolved. Before committing to any mortgage agreement, applicants would do well to find out specifically what the lender can and cannot do if debt deflation impairs the value of the asset or assets used as collateral for the loan.
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