The Hindu Business Line : Housing loan as a put option

DO YOU know that your mortgage loan can be used as a put option on the property? Consider this: You have borrowed Rs 11 lakh and purchased a house for Rs 15 lakh. Your primary collateral will be the property itself. This essentially means that the home-loan company will take your property if you default on the loan obligations.

Now, suppose the property values fall across the country, and your house is now worth only Rs 10 lakh. This means that your equity in the property is negative.

Why? Remember, you invested only Rs 4 lakh to buy the property. Your investment is currently negative because the property value has fallen by Rs 5 lakh.

What can you do? You can either hold your property, in the hope that it will appreciate someday. You can sell the property, but that will be costly and time consuming. The last option is to default on your mortgage loan! When you default, the home-loan company will take your property. That, in effect, is selling the property to the home-loan company.

Since you have the choice of selling the property to the home-loan company, it has the characteristics of a put option. Why exercise the put option? When you are certain that the property value will not increase to the original levels, you may think it fit to restrict your losses to your investment of Rs 4 lakh plus the mortgage payments.

But this will be an attractive proposition only if you do not provide any collateral apart from the property itself. Otherwise, the home-loan company can seize other assets to set off the amount you owe. This is surely to prompt you to default. It is just to show that mortgage loan can be a useful portfolio management tool.

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