Question

Who are the winners and losers when a mortgage company lends \(\$ 100,000\) to the Miller family to buy a house worth \(\$ 105,000\) and during the first year prices unexpectedly fall by \(10 \%\) ? What would you expect to happen if the deflation continued over the next few years? How would continuing deflation affect borrowers and lenders throughout the economy as a whole?

Short answer

Short Answer: In this situation, both the Miller family (borrowers) and the mortgage company (lenders) face potential losses. The Miller family experiences a decrease in the value of their house, which could make it difficult for them to sell the property and repay the loan. Meanwhile, the mortgage company faces the risk of default on the loan, as the property securing the mortgage is now worth less than the amount they lent out. If deflation continues, this scenario could negatively impact both borrowers and lenders in the economy as a whole.

Step-by-step solution

Calculating initial loan and property value after a year

Initially, the mortgage company lends the Miller family \(\$100,000\) to buy a house worth \(\$105,000\). Over the first year, the house prices fall by \(10\%\). We need to calculate the new value of the house after one year. Let's find the house value dropping after a year: New Value = Initial Value - (10/100 * Initial Value) New Value = \(105,000 - (0.1 * 105,000)\)

Identifying winners and losers

In this step, we will look at how the different parties are affected by the drop in the house prices: 1. Miller Family (Borrowers): As the house prices fell over the first year, the value of their house decreased, creating a possible situation whereby the loan amount is greater than the house's worth. 2. Mortgage Company (Lenders): The lenders might face potential losses, as the property securing the mortgage is now worth less than the amount they lent out.

Extrapolating scenario if deflation continues

Assuming that the deflation continues over the next few years, this could lead to further reductions in the value of the house while the mortgage amount remains the same. 1. For Borrowers: Continuing deflation may negatively affect the Miller family, making it more difficult to sell the house at a price that would be enough to cover the mortgage. 2. For Lenders (Mortgage Company): The mortgage company would be at an increased risk of default on the loan, as borrowers might find themselves unable to repay the loan without sale of the property.

Analyzing effects on borrowers and lenders in the economy as a whole

If deflation continues in the economy as a whole, it's likely to affect not just the Miller family and the mortgage company but other borrowers and lenders as well. 1. For Borrowers: In general, continuing deflation places a burden on borrowers across the economy, as they would face decreasing asset values, difficulty in selling assets to repay loans, and potential increases in unemployment, further hindering their ability to repay loans. 2. For Lenders: Lenders throughout the economy may experience increased risk, as borrowers become less likely to repay their loans. This could lead to a rise in default rates, financial losses, and potentially a negative impact on the financial health of lending institutions.

Key concepts

Borrowers

Borrowers, like the Miller family in this scenario, take out loans to finance significant purchases such as homes. When deflation occurs, and prices drop unexpectedly, borrowers might experience some unexpected challenges.
- If the price of their home decreases, the value of their asset reduces. This situation is referred to as being "underwater."
- In an underwater situation, the amount owed on the loan is more than the current market value of the home.
This can be problematic as it restricts their ability to sell the home for a price that can cover the outstanding mortgage.
If deflation continues, borrowers across the economy might endure difficulties:
- Lower asset values can make it harder to secure refinancing or additional loans.
- Borrowers may face increased financial strain if wages do not keep pace with their debt obligations.
Planning and careful financial management become crucial for borrowers under these conditions.

Lenders

Lenders, such as mortgage companies, also face challenges during deflation. Deflation affects their financial health as the security of the loans they have issued diminishes. Here’s what lenders generally experience:
- The collateral value, like the house in this case, drops in relation to the loan they provided.
- They encounter heightened risks of default if borrowers are unable to continue repayments.
Persistent deflation can have broad implications for lenders:
- An increase in default rates may lead to financial instability for these institutions.
- The decrease in the value of collateral might prevent lenders from recovering their funds.
Therefore, lenders tend to scrutinize potential borrowers more rigorously during deflationary periods to mitigate risks.

House Prices

House prices are significantly impacted by deflation, which can lead to a broader economic downturn. **Deflationary effects on house prices include:**
- A decrease in market demand for homes, contributing to lower prices.
- Sellers may find themselves in distress as they can't sell their homes for amounts that cover their mortgages.
Over time, continuing deflation can spread fear in the housing market:
- Potential new buyers might hesitate to purchase fearing further depreciation.
- Existing homeowners may delay selling, resulting in a stagnant market.
Overall, deflation creates a negative cycle, as declining house prices may discourage economic mobility and investment in new developments.

Mortgage

A mortgage is a loan specifically designed for purchasing property. In this scenario, the mortgage remains a constant obligation despite fluctuating house values due to deflation:
- The mortgage amount stays fixed, whereas the property value drops.
- Borrowers still owe the original amount borrowed, despite the house being worth less.
In a deflationary environment, holding a mortgage presents challenges:
- Potential difficulty in refinancing appears if the home value falls below the balance of the mortgage.
- Families might consider strategies like leveraging savings or external financial assistance to manage mortgage repayments.
Adjusting loan terms, if possible, or consolidating debts might also offer some relief for borrowers striving to manage their mortgage obligations during deflation.