What is Debt Deflation?

Also known as collateral deflation or worst deflation, debt deflation is a situation where 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 in order to keep his or her degree of risk within an acceptable range. While lenders typically try to avoid the acceptance of collateral that exhibits some potential for losing its worth during the life of the loan, even assets that are considered likely to appreciate in value may fall victim to debt deflation under the right circumstances.

One way to understand the impact of debt deflation is to consider the granting of a mortgage to purchase a home. At the time the loan is approved, the market value of the home is slightly more than the total amount due on the mortgage. With this in mind, the lender is willing to accept the real estate being purchased as the collateral for the loan. In many situations, the property will either appreciate in value over the years, or at least hold 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.

Should that property depreciate rather than appreciate in value, the lender will compare the current market price that the property can command with the remaining balance of the mortgage. If the rate of debt deflation accelerates, and eventually surpasses the value of the property, this places the lender in a high-risk situation, since the ability to sell the property and cover the outstanding balance of the mortgage no longer exists. At this point, the lender may attempt to renegotiate the mortgage as a means of minimizing the risk, or even call the loan due if the property is anticipated to continue depreciating and the chance of a default is imminent.

The actions that a lender can take when debt deflation occurs will be governed by regulations put in place by governmental agencies that oversee the purchase of property within the borders of the nation where the mortgage is written. In some instances, the option to call the mortgage is limited, in that the lender cannot call the mortgage due until the value of the property falls below a certain amount, or the homeowner actually misses a certain number of consecutive payments on the loan. This type of checks and balances help to minimize the opportunity for lenders to call mortgages based on short-term situations that temporarily cause the collateral to lose value that it ultimately recovers once those situations are resolved. Before committing to any mortgage agreement, applicants would do well to discover specifically what the lender can and cannot do should debt deflation undermine the value of the asset or assets used as collateral for the loan.