House value depreciation – what to expect if this happens

While the last few years have seen real estate prices only going up north, there’s no assurance they won’t turn around and go south. While property value decrease is good news to prospective buyers, it can have a “unsettling effect” to borrowers with a home loan…especially if the house value goes down below the outstanding principal loan amount. For those who purchased a house to live in, it becomes the proverbial hot ghee that is hard to swallow or spit out. Also, for those who purchased the house as a short term investment, it quickly becomes a bad asset.

Why does property value decrease

Higher interest rates make housing less affordable, so demand decreases and home prices fall. Then, as economic activity slows and interest rates decline, housing again becomes more affordable and, consequently, demand and prices go up. – Bankrate.com

Real estate, especially commercial real estate, is a cyclical market. As with everything else, supply and demand determine real estate prices. Real estate supply and demand depend on various factors and aren’t consistent across locations. Some of the factors are listed below:

• Inflation / higher interest rates: One of the measures to contain inflation is to increase interest rates. Higher interest rates mean higher EMI, which means many cannot afford it and hence demand falls
• Economic slowdown and higher rates of unemployment: People without jobs cannot pay rent or EMI amounts
• Bursting of housing bubble: Factors that contribute to housing bubble include historically low interest rates, relaxed lending standards, failure of regulators to intervene and speculative fever. When a significant percentage of home buyers are short term investors, its a sure sign of housing bubble. When the bubble bursts, loan defaults increase and supply of vacant homes in the market increases

What to expect?

Indian banks fund 70 – 85% of the registered property price. If the property price goes down below outstanding loan amount, the bank may ask the borrower to pre-pay an amount that brings the outstanding principal amount to 70 – 85% of the revised property price or provide additional collateral. At any point during the loan tenure, the bank doesn’t want to be exposed to more than 85% of the property price.

If the borrower fails to provide extra collateral or pay that amount within a reasonable time period, the bank is legally entitled to seize the property and sell it to a potential buyer to recover its dues. The “depreciation of security” clause of your home loan typically reads: “If any property on which the security for the loan is created depreciates in value to such an extent that, in the opinion of the bank, further security should be given and such security is not given….”

Let’s say you bought a house / apartment worth Rs. 60 lakhs two years ago with the bank providing 20-year home loan of Rs. 51 lakhs (15% of the property value) at 10.5% interest rate. At the end of 2nd year, you would have spent a total of Rs. approx. 21 lakhs (Rs. 9 lakhs downpayment + approx Rs. 12 lakhs in EMI) on the house. Your outstanding Principal would still be approx. Rs. 49 lakhs because a major portion of your EMI payment goes towards reducing interest amount during the first several years and principal amount during the last few years.

If the house price falls to Rs. 46 lakhs, the bank will still finance only 85% of the current price – approx. Rs. 39 lakhs. The borrower will have to pay the shortfall – approx. Rs. 10 lakhs – to avoid bank repossession. After paying this shortfall, the buyer is already short Rs. 31 lakhs and is yet to pay additional Rs. 1.02 crores in the next 18 years to take possession of a house that’s currently valued at Rs. 46 lakhs. Use the EMI Calculator to check this out yourself.

What are the options for additional collateral?

Provide more collateral in terms of other investments including gold, NSC, another property, equities or bonds. Stocks and mutual funds aren’t recommended because if their market value goes down, the bank may sell it and / or ask for more collateral.

How to avoid such situations in future?

Avoid property purchase during housing bubbles. Sooner or later, the bubble will burst. If you have already purchased one, attempt to make additional payments over and above the monthly EMI payment. That amount will go against reducing the outstanding principal amount and reduce your total payment against interest amount.