Negative equity is not just a problem for homeowners who want to sell their homes: borrowers may also find themselves unable to shop around for better deals, writes Caroline Madden

SOME SAY it's purely a theoretical problem unless you have to sell your home, while others have compared it to burning €50,000 in cash in your back garden. So is negative equity worth losing sleep over or has the issue been blown out of proportion?

Negative equity occurs when a mortgage is greater than the value of a property. As property prices have fallen nationally by 12.1 per cent since February 2007 - at least according to the Permanent TSB/ESRI house price index which measures mortgage drawdowns - borrowers who took out high loan-to-value mortgages and in particular 100 per cent mortgages and bought at the peak have been pushed into negative equity.

In the summer of 2005, First Active broke new ground with the introduction of the first 100 per cent mortgage in the State - making it possible for first-time buyers to get onto the property ladder without scrimping and saving for a deposit.

Other lenders quickly followed suit with EBS, First Active, Ulster Bank, Permanent TSB and Bank of Scotland soon offering similar products. However, in recent months lenders have effectively withdrawn 100 per cent mortgages from the market.

It is difficult to pin down exactly how many of these loans were taken out, as no official cumulative figures have been collated and the banks have been understandably coy on the subject, but it is estimated that one-third of all first-time buyers in 2006 opted for 100 per cent finance, which equates to 12,350 home loans.

In 2007, 5.5 per cent of loans provided were 100 per cent mortgages, which amounts to almost 8,700 mortgages. So, at a conservative estimate, 21,050 homeowners have 100 per cent mortgages and are therefore extremely vulnerable to negative equity.

Of course it's not just those who borrowed the full price of their home who are at risk. Given the magnitude of the recent fall in property prices, anyone with a high loan-to-value mortgage is in the danger zone. According to Davy Stockbrokers, 69 per cent of first-time buyers in 2006, which equates to roughly 25,570 mortgages, had a loan-to-value ratio of more than 90 per cent.

Davy has predicted that 40,000 first-time buyers would face an average paper loss of €18,200 if house prices fall by 10 per cent this year. Prices have already fallen by 5 per cent in the first half of the year according to the Permanent TSB/ESRI figures and anyone in the market will tell you that where properties are selling at all the fall is far greater.

Jim Power, chief economist with Friends First, predicted last month that house prices would drop by a further 10-15 per cent before the market bottoms out. This would drag even more homeowners into the negative equity net. "Anybody over an 80 per cent [loan-to-value] mortgage certainly would have an issue," Power said this week.

This isn't the first time that negative equity has reared its head in the Irish property market, but it has never occurred on this scale. Power recalls that there was "modest" negative equity in the late 1980s, a situation that lasted for about three years.

He expects that the problem will be "much more sustained" this time around, because the average loan-to-value ratio is so much higher now than in the late 1980s, when lenders were far more conservative in their approach, and the correction in houses prices is so much more severe.

The British housing market experienced a major crash in the late 1980s and early 1990s that left 1.7 million borrowers in negative equity.

According to Martin Ellis, chief economist at Halifax, UK house prices fell by 13 per cent from a peak in 1989 to a trough in 1995, and didn't recover to the 1989 level until 1998, almost a decade later.

Certain areas were hit much harder than others, and took longer to recover. East Anglia and London were two of the worst-affected regions, dropping 34 per cent and 28 per cent respectively. London had recovered by 1998, but prices in East Anglia only got back to pre-crash levels at the end of 2000.

It is expected that the Irish property crisis will also have a disproportionate effect, with certain areas, such as satellite towns, taking longer to recover.

One reason for this is the concentration of first-time buyers with 100 per cent mortgages in these towns. Because they are now mired in negative equity, they may not be in a position to sell their homes. Even if they are, supply is outstripping demand in these areas, so finding a buyer would be difficult.

Austin Hughes, economist with IIB Bank, says a number of factors - when combined with the concentration of negative equity in these areas - may contribute to the uneven spread of any further deterioration, or indeed recovery, across the property market. For example, purchasers in satellite towns tend to be "more vulnerable on the jobs front as well," he says.

Clearly, negative equity is a distressing scenario to find yourself in, but just how serious is it from a financial perspective?

"It's a hard situation, but going into negative equity doesn't mean you're going to get put out of your home," points out Karl Deeter, head of operations at Irish Mortgage Brokers. "It does mean that you owe more than the property is worth but, while that's disappointing, it's not the end of the world."

Still, he concedes: "It's not a nice feeling. If you ever want to experience it, go into the back yard and set €50,000 on fire and you'll have a similar emotion."

One of the standard retorts when the emotive issue of negative equity is raised is that it's not a problem if the borrower doesn't have to sell up. Your house may have depreciated in value since you bought it, but as long as you can meet your monthly repayments, negative equity won't have a negative impact on your credit rating. As long as you can ride out the property market slump, negative equity will remain a theoretical issue as you won't have to realise the paper loss, we are constantly reminded.

First-time buyers who bought when the market was at its peak will have a long wait on their hands, though. According to the Permanent TSB/ESRI house price index, the average price paid by first-time buyers fell from €279,400 in February 2007 to €246,529 in June.

This suggests that first-time buyers who took the plunge at the peak are now in negative equity to the tune of €32,871, and would need an 11.8 per cent recovery in prices to get out of the red. They can only hope that this property crash isn't as prolonged as the UK experience in the 1990s.

But what if a homeowner doesn't have the option of riding out the storm? What if they need to relocate for work, or trade up in order to make room for a growing family? Unfortunately, if they've fallen into the negative equity trap, selling may not be a viable option.

Michael Dowling of the Irish Mortgage Advisers' Federation explains that homeowners need the consent of their lender if they wish to sell their property in a situation where the sale proceeds won't be sufficient to pay off the mortgage.

"It is very important that you sit down with the bank and discuss with them the situation you're faced with," he advises. "You either have to come up with the difference from an alternative source or, if there are extreme circumstances, the bank may . . . give you some time to make up the differential."

In theory, lenders have the right to refuse to let the borrower sell the property, Dowling says, but in practice, banks are willing to negotiate and try to reach a workable arrangement, particularly where the property in question is the person's principal private residence.

For many people, though, coming up with the lump sum necessary to cover a negative-equity shortfall will not be possible and they will have no option but to stay put.

But as long as you have no need to sell up, negative equity isn't a problem, right? Wrong.

Borrowers who sit tight may avoid taking a hit on the capital loss, but they can find themselves trapped with a lender who is offering uncompetitive rates - and unable to shop around for better deals.

Many first-time buyers who took out 100 per cent mortgages in 2006, for example, are now coming off cheap two-year fixed rates, rolling onto much more expensive rates and facing nasty repayment shocks.

"Unfortunately, there's no option for that consumer other than to stay with their existing bank, because nobody is lending 100 per cent finance at the moment, and they could be at a situation where they might be at 105 per cent or 110 per cent loan-to-value," explains Dowling.

Homeowners trapped by negative equity are also sitting ducks for charges such as First Active's €125 administration fee introduced in July, which applies where a customer wants to move onto a fixed-rate mortgage from a tracker or variable-rate mortgage, or to take out a top-up mortgage.

Because banks have tightened up their lending criteria, it is now very difficult for a borrower to switch to another lender unless their loan-to-value ratio is 80 per cent or lower.

So even if they aren't in negative equity, unless they have a low loan-to-value mortgage, First Active customers who wish to take out a top-up mortgage or move onto a fixed rate have no choice but to pay this administration fee, as they will not be able to move elsewhere.

"You're being treated in a . . . disdainful fashion because you've now got to pay a fee for the privilege of taking out an additional loan with your lender," says Dowling.

"We would strongly advocate that no other lenders should follow the road of First Active," he adds. "It's [abusing] a dominant position with a given customer base."

Jack Fitzpatrick, chairman of the Professional Insurance Brokers' Association, highlights another problem arising from the negative equity trend. Some people bought their home on the assumption that the value of the property would rise, and with the intention of releasing equity and using it to renovate the property or perhaps to pay off credit card or other debt.

Instead, the value of their home has actually fallen below the level of their home loan, so the option of restructuring their mortgage has vanished, and their plans have had to be shelved indefinitely.

Karl Deeter of Irish Mortgage Brokers also raises the prospect of longer-term fallout from the current squeeze based on the presumption that negative equity is largely likely to hit a certain age cohort - younger first-time buyers.

"The problem is that, when you have a whole generation, say between 20 and 35, who will experience this kind of financial punishment, it has implications for the wider economy and how it will perform in the future - as well as for people's attitude towards finance and debt and what they'll pass on to their children."