Usufructuary Mortgages in Rural South Asian Economies

Abstract

Abstract. A section of the informal credit market in an agrarian society is explored, namely the usufructuary land mortgage, a type of money‐lending contract that is common in rural economies of South Asia. In this type of transaction, the lender charges no explicit interest on the loan, but since the mortgagee is free to utilize the land for his own cultivation, net income from the land is, in effect, an implicit form of interest payment. Issues relating to the determination of the rate of interest and the oft‐found phenomenon of undervaluation of the collateral are discussed. A model is provided that shows the proper relationship between undervaluation of collaterals and the high implicit usufruct rates of interest. This relationship can only be understood by defining the opportunity cost of money in terms of purchasing new land. It is shown that, for any rate of default less than 100%, return from money lending is lower than return from land purchase under certain circumstances. It is then argued that undervaluation of collateral may be a mechanism to compensate the lender for the opportunity cost of his funds.