What Is Debt Deflation?

Debt deflation is a concept that pertains to the effects of debt on the price of properties, goods, and services. Borrowers will typically experience decreasing property values from debt deflation, which can lead to an array of other 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.

Understanding Debt Deflation

In contrast to inflation, which is a period of rising prices, deflation is characterized as a period of falling prices. Debt deflation occurs when a debt bubble has burst and prices fall. It can have broad-ranging market and economic effects. For example, real estate and specifically property values can be highly susceptible to debt deflation, which can cause distress for mortgage borrowers.

Key Takeaways

  • Debt is an important component that can help to stimulate economic growth for both businesses and consumers.
  • Debt deflation, which often occurs after a debt bubble has burst, happens when too much debt depresses the value of properties, goods, or services.
  • Mortgage debt is susceptible to debt deflation because it is a large portion of the total debt outstanding overall.
  • Declining property values can lead to underwater mortgages, even foreclosures, when debt deflation strikes the mortgage industry.

Debt is an important component of an economy that can help to stimulate growth for both consumers and businesses. It generally goes through cycles that 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.

Example of Debt Deflation

The mortgage market is one area highly prone to debt deflation since it encompasses a large portion of the total debt outstanding overall. In a debt-deflation cycle borrowers can struggle with paying their mortgage debt and decreasing property value of the collateral used to secure their debt in a mortgage loan. It can lead to higher rates of foreclosure.

High volumes of debt and high rates of default have a deflationary effect on a borrower’s secured mortgage collateral. Lower collateral values, in turn, 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, for example, 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 match the value of the property. 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.