Debt Deflation

What is 'Debt Deflation'

Debt deflation is a concept that pertains to debt’s effects on the price of properties, goods and services. Borrowers will typically experience decreasing property values from debt deflation which can lead to many negative repercussions. In the broad market, debt deflation generally refers to a theory that identifies total outstanding debts as a catalyst for price decreases across a country’s economy.

BREAKING DOWN 'Debt Deflation'

Debt deflation can have broad ranging market affects. Real estate and specifically property values can be highly susceptible to debt deflation which can cause distress for secured mortgage borrowers.

Broad Market Debt Deflation Affects

Debt is an important component of an economy that can help to stimulate growth for both consumers and businesses. It generally goes through cycles which influence the amount of debt issued and the categories of debt in high demand. When debt issuance reaches new peaks it can deflate the value of real currency. As debt issuance increases, the risk for default rates are also higher. The mortgage market is one area highly prone to these affects since it encompasses a large portion of the total debt outstanding overall.

Highly concentrated lending categories such as mortgage debt are the most likely to show affects when debt deflation occurs. For the mortgage market these affects can lead to decreasing collateral values and higher rates of foreclosure.

Debt Deflation and Mortgage Collateral

High volumes of debt and high rates of default have a deflationary effect on a borrower’s secured mortgage collateral. In a debt deflation cycle borrowers can struggle both with paying their debt and a decreasing value of the collateral used to secure their debt in a mortgage loan.

Lower collateral values can lead to underwater mortgages, losses in property return on investment and limits to available equity. These can all be problems for a borrower with activities pertaining to their real estate collateral. In an underwater mortgage, the borrower’s loan balance is higher than the secured property’s value which requires them to stay in the home until the balance can be paid down enough to cover the costs of a sale. This also gives a homeowner no equity in their home for which to obtain a home equity loan or other credit products tied to the collateral’s equity value. If the borrower must sell they would be required to take a loss and would owe the lender more than the cost of the proceeds from a sale.

If a borrower finds themselves in an underwater mortgage in distress and nearing foreclosure then they may also have other considerations beyond just the loss of their property, specifically if their mortgage has a full recourse provision. Non-recourse provisions can help a borrower in distress while full recourse provisions require them to pay additional capital to the bank if the value of their collateral does not cover its credit balance. A full recourse provision benefits a lender in an underwater mortgage since it also gives the lender additional rights to other assets to account for the difference in property value.