Debt deflation occurs when the value of an asset used as collateral for a loan decreases, leading lenders to adjust loan terms. This can put lenders at high risk if the property’s value falls below the remaining mortgage balance. Regulations govern lenders’ actions in such situations.
Also known as collateral deflation or worse deflation, debt deflation is a situation in which the value of the asset that is used as collateral for a loan decreases in value. When this occurs, the lender may find it necessary to adjust the terms and provisions of the loan to keep its degree of risk within an acceptable range. Although lenders generally try to avoid accepting collateral that exhibits some potential to lose value over the life of the loan, even assets that are considered to be of appreciable value can fall victim to debt deflation in the right circumstances.
One way to understand the impact of debt deflation is to consider taking out a mortgage to buy a house. At the time the loan is approved, the market value of the home is slightly more than the full amount owed on the mortgage. With this in mind, the lender is willing to accept the real estate being purchased as collateral for the loan. In many situations, the property will appreciate in value over the years, or at least maintain its initial value. As a result, the lender is secure, knowing that even if the homeowner defaults on the mortgage, the property can be sold and the balance due on the loan recouped.
If that property depreciates instead of appreciating in value, the lender will compare the current market price the property can command against the remaining balance on the mortgage. If the rate of debt deflation accelerates and eventually exceeds the property’s value, this places the lender at high risk, as the ability to sell the property and cover the outstanding balance on the mortgage is no longer there. At this point, the lender may attempt to renegotiate the mortgage as a means of minimizing risk, or even pay off the past-due loan if the property is expected to continue to depreciate and the possibility of default is imminent.
The actions a lender can take when debt deflation occurs will be governed by regulations set forth 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 call the mortgage is limited, as the lender cannot pay off the overdue mortgage until the property’s value falls below a certain amount, or the homeowner actually misses a certain number of consecutive payments. of the loan. These types of checks and balances help minimize the opportunity for lenders to apply for mortgages based on short-term situations that temporarily cause collateral to lose value that is eventually recovered once those situations are resolved. Before committing to any mortgage deal, applicants would do well to find out specifically what the lender can and cannot do if debt deflation undermines the value of the asset or assets used as collateral for the loan.
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