Interest-free loans - at a cost

Developers' incentives may serve to keep property prices artificially high, writes Fiona Reddan

THE HEADY days of the Celtic Tiger property boom were firmly put to rest this month with the news that developers are offering interest-free loans on the purchase price of new properties to encourage buyers to start spending money again.

It's all a long way away from the boom years when developers were besieged with buyers at the launch of new housing schemes and prices rose by tens of thousands of euro overnight.

Developers such as Ray Grehan of Glenkerrin Homes and Bernard McNamara have taken their lead from the British market, where similar schemes have been on the market for a number of years, such as the "EasyBuy" option available on properties sold by Crest Nicholson. In this scheme, the developer grants purchasers as much as a 25 per cent interest-free loan.

But do such schemes represent a credible effort by private developers to revitalise the faltering property market, or are they simply masking the reality that prices need to fall further before activity returns?

The schemes are based on the assertion that the slowdown in the Irish housing market is not due to the fact that property is over-valued, but rather to the global credit crunch and the resulting liquidity problems facing lenders, which are being passed on to consumers.

To address this situation, developers such as Glenkerrin and McNamara have stepped in to make up the difference between what the banks are now willing to lend people based on a multiple of salary and savings for a deposit, and what they want to charge for their properties.

Glenkerrin is offering a "Home Purchase Choice", which involves a 15 per cent interest-free loan over seven years on the cost of properties across three developments in Dublin, including the Grange in south Dublin.

McNamara has already cut the prices at his Elm Park development on Merrion Road in Dublin by 20 per cent and, instead of cutting prices further to stimulate demand, he is offering interest-free loans of up to 30 per cent over five years for purchasers in the development.

At first glance, the schemes look attractive, with purchasers benefiting from reduced deposits, lower interest payments and cheaper capital repayments for the term of the interest-free loan.

At Glenkerrin's developments, purchasers only have to come up with a 5 per cent deposit. So on a purchase price of €500,000, only €25,000 needs to be saved, as opposed to the €50,000-plus that the banks now demand when buying in the traditional manner.

A bank will lend 80 per cent of the purchase price, while Glenkerrin will provide the remaining 15 per cent interest-free by way of a second charge on the property.

The purchaser will own 100 per cent of the property, with the developer's claim coming after the lending bank.

Moreover, for the first seven years, purchasers will pay less interest. On a purchase price of €500,000, they can expect to save approximately €20,000 in interest payments during this period. Purchasers will pay reduced monthly repayments for the term of the interest-free loan, for example, €2,398.20 compared to €2,697.98 for a mortgage of €450,000.

The Glenkerrin scheme does offer some protection to buyers should house prices continue to fall. By basing the proposition on the property's market value, rather than a fixed sum, the developers stand to lose if the property falls in value over the period of the loan. For example, if the homebuyer pays €500,000 for a property, but its value has decreased by €100,000 at the time of repayment, then the house purchaser will only have to pay back €60,000, instead of €75,000 at today's prices, with Glenkerrin taking the hit.

So far, so good. But what happens when the five- or seven-year interest-free period is up? Buyers will be called upon to repay significant sums of money. In the case of Elm Park, which is offering up to 30 per cent of an interest-free loan, it could be as much as €141,000.

And, in the case of Glenkerrin Homes's offer, prospective homeowners initially faced the prospect of paying a premium at the end of the seven years as the 15 per cent payback was to be calculated on the value of the property at that time, not when it was bought. However. in a move likely to make the offer more appealing, Glenkerrin has now said that it will cap the 15 per cent on the basis of the price paid for the property.

How will homebuyers fund this deficit? It won't be a question of saving every month because, if they could do this now, surely purchasers would opt to pay for 100 per cent of the property today. Instead, purchasers will most likely have to remortgage when the time period elapses in order to pay back the developer.

While they may be betting on rising values to translate into lower loan-to-value ratios by this time, thereby making a refinancing easier to come by, the reality is that, if the banks aren't willing to lend the full purchase price today, they may be equally unwilling to do so in five years - or they may do so at uncompetitive interest rates.

If purchasers are unable to raise the finance to pay back the developer, this may lead to a glut of properties coming on to the market at the same time, pushing prices down even further.

Moreover, if the developers cannot sell the properties on a 100 per cent basis and need an interest-free loan to incentivise purchasers, basic economics mean this is because there is no demand at that price. That means the properties are overvalued. In order to sell, the only logical conclusion should be to reduce prices.

However, developers prefer to offer incentives to housebuyers rather than simply cut prices. This maintains the value of their investments and, as developers have borrowed money based on certain valuations of their properties, they are loath to lead a fall in values.

Rather than react as the market demands and cut prices, developers are artificially discounting their properties to more realistic prices by asking for only 70 or 85 per cent of the purchase price today. At the same time, they maintain property values by recouping the outstanding amount at the end of an agreed period.

There is an argument for consumers to pursue further price reductions rather than accept incentives. As shown in the accompanying table, in addition to paying a lower price for the property, purchasers will also save significantly in terms of interest payments over the life of the loan.

There are also some outstanding issues with regard to the viability of some schemes. The Irish Financial Services Regulatory Authority is investigating whether it should regulate such schemes, while the main mortgage banks have yet to commit to lending on the basis proposed.

Simply Mortgages is acting as mortgage broker for Glenkerrin's offer. Peter Bastable, managing director with the firm, says the scheme was launched in advance of formal agreements with lenders, and bankers are currently debating how they would lend under such a scheme.

While he expects that three to five lenders will offer to lend under the scheme, it will take some weeks before formal agreements are made and, in the interim, buyers will not be able to avail of the 15 per cent offer.

One of the issues the banks are contending with is how to treat the 15 per cent loan. For example, does it classify as a consumer loan? Another issue is whether the lender underwrites the affordability of the purchaser at 80 per cent or 95 per cent.

So, while such schemes may succeed in their attempts to hold up the property market, and offer consumers certain attractions, including lower capital and interest payments in the early years, the commitment to a deferred payment may see homebuyers agreeing to purchase over-valued properties, which they will have to finance fully at some stage, and may contribute to a falsification of property prices.

Whether such schemes succeed, for developers, the announcement of the incentives has at least generated publicity for the properties they are seeking to offload.

For consumers, it may be an indication that more sizeable price cuts are yet to come.