Tread warily and avoid the trap

New house buyers could still fall victim to negative equity, but there are ways to reduce the risk. Richard Phillips explains

So what if the housing market is on the up? There are still around 400,000 homes in this country with negative equity. The grim memories are fresh, one more thing for new buyers to worry about, one more hazard to avoid.

The implications of negative equity - when the value of your property falls below the value of the borrowings you have taken out to fund its purchase - are painful and not quickly forgotten. You live day to day knowing that the mortgage you are saddled with is greater than the value of your house. If you wish to sell you will realise a loss and although these days mortgage companies will allow you to transfer the debt to a new home, you may still end up having to dig deep into your own pockets. If you want to get out of the market altogether, perhaps to rent or because your circumstances change and you can no longer afford to own a property, you will have to find the shortfall to pay back to the bank.

Negative equity is not new and there is no guarantee that it will not recur. It is the direct result of a fall in property prices and house prices have a tendency to collapse every so many years. However attractive reports of surging prices now may be, they should be treated with caution. A renewal is underway but should not be seen as carte blanche to buy without examining ways to reduce the possibility of negative equity in another downturn. While economists can see the number of households in negative equity declining to more manageable proportions by the turn of the century, there will still be pockets which refuse to budge.

Figures from the Halifax show that the main improvement is confined entirely to the South-east and more specifically greater London. The Halifax reported figures for November and December indicating an annual rise in prices of 8.4 per cent last year. Much of this was confined to greater London, however. In the north, house prices only rose 0.6 per cent.

And there is no guarantee that the market will not suffer setbacks over the next five years. Robert Thomas, housing economist at investment bank UBS, is quite clear on the prospects for negative equity: "Yes, it probably will come back." The market has always had its ups and downs, he explains, but when inflation was running at a high level through the 70s and 80s, declines were often masked by inflation. With inflation at three per cent, or less, and looking set to stay that way, there will be less relief.

There are several ways to minimise the impact of another downturn. Your building society can help; as can your estate agent. If you treat buying a house as an investment, then a number of solutions present themselves naturally. What people hope for from an investment is that it performs better than other investments, and also beats investments of a similar catgeory. For example, if you buy shares, you do so because you hope they can outperform gilts, or a savings account. But you also hope your shares will outperform others on the market. The same is true of houses. To limit negative equity, you need to buy a property that performs less badly than other properties in a downturn; and ideally, and - possibly wishful thinking - outperforms the rest of the market when prices are rising.

Point one then - the old estate agent's adage - location, location and location. Alan Gottschalk, a regional director at Black Horse Agencies, says try to buy the best property, in the smartest location you can afford. Experience shows that houses lose less in value and recover quicker than properties bought by first-time buyers, which form a smaller part of the overall market.

He also cautions against trying to spot up-and-coming locations. If you guess right, such a move can be lucrative; but it is a gamble. Many such areas fail to live up to expectations.

The choices you make when structuring your finance can also be important. Ian Darby, marketing director at mortgage brokers John Charcol, says one of the most sensible options is to opt for a repayment mortgage, as opposed to an endowment policy. Endowment policies, with your investment only maturing towards the end of the mortgage life, means that you are not pumping any cash into the property. If there is a fall in prices, at least with a repayment mortgage you are enhancing equity in the property.

Mr Darby also warns that a 100 per cent mortgage can be dangerous for first-time buyers. Far better to try to raise as large a deposit as you can. Although that could be wiped out if prices fall, you have more flexibility when it comes to selling. If you can't afford much in the way of a deposit, try not to borrow through a separate lender to raise the money. If interest rates go up, then you won't be hit so hard by the higher repayment schedule on a short term loan or credit card debt.

Several lenders operate schemes to help borrowers caught in negative equity: make sure your lender has one, and try to make sure there is a clause in the loan for this eventuality. It can save you months of negotiation.

It is also important how long you expect to stay in the property. If you can see it as a home where you will be for the next 10 or 20 years, you can afford to take a more relaxed view. But if, because of your job or other factors, you may have to up-sticks and move within a few years, then you need to be sure you are well placed for all eventualities.

TIPS

Finance

Try to raise as large a deposit as possible.

Make sure all your borrowings are under one roof and on your mortgage. Avoid short-term borrowing - credit cards and bank loans.

Opt for a repayment rather than an endowment mortgage.

Check what service your mortgage lender offers to borrowers who find themselves in negative equity.

Property

Buy the best property you can afford. A small house in a decent area, will probably do better in a downturn than a larger one in a run-down area.

Try not to second guess the market by speculating on an up-and-coming area unless you are really happy with the property you are buying. In a downturn prices tend to recover more quickly - and drop less sharply - in an established area.