Want to avoid the negative equity trap? Build your own home

For years, the term "negative equity" barely featured in the vocabulary of the modern homeowner. But things have changed. The Bank of England revealed last week that 1.2 million homeowners are likely to find themselves trapped in a home worth less than the mortgage secured against it as prices continue to tumble. But one type of homeowner could be better equipped to fight the return of negative equity than the rest – those who build the homes they live in.

Self-builders benefit from an average 35 per cent equity gain from the day they move into the property, according to John Hay, marketing director at self-build specialist BuildStore. "When the house is complete, it should be worth around 35 per cent more than the total cost of the land and the build. This cushion against negative equity means that now is the perfect time for self-build."

Specialist self-build mortgages lend against the land first and then the cost of the building work, including materials, labour and fees such as the surveyor's. The funds are released in stages to match the increased value of the structure.

The reining in of lending criteria on self-build mortgages has, to date, been relatively minor, says Ray Boulger, technical manager at broker John Charcol. "Self-build is one of the sectors that have been affected least by the downturn as the very nature of the beast addresses negative equity issues from the start. It also only accounts for a very small proportion of mortgage lending."

For example, while Norwich & Peterborough building society will still lend 85 per cent loan-to-value on the purchase price of the initial plot of land, it will now only lend 85 per cent on the total cost of the build, compared to its former offering of 90 per cent. So if the land was £100,000 and the build cost was £150,000, borrowers can now access a maximum of £212,500, as opposed to £220,000.

The lender releases this sum in seven stages – such as "foundations", "wall plate level", "roofing" and "plastering" – in doses of up to 20 per cent of the total. Each stage is valued by the lender separately before the next tranche is released. At the point of completion, 100 per cent of the funds will have been accessed. This total borrowing must not exceed 85 per cent of the final value of the property, according to Richard Barker, product manager for mortgages at N&P.

And while N&P has raised interest rates on self-build mortgages, it is only by a small amount, particularly when compared to what has happened since the credit crunch started a year ago in the standard market. For example, a five-year, fixed-rate mortgage on a self-build project is priced at 6.89 per cent, compared to the equivalent standard deal for a property purchase priced at 6.64 per cent. This is a far smaller differential than was the case before the credit crunch started.

The lender's most important buffer is that each tranche is lent in arrears, not in advance, so borrowers will have to stump up the cost of the first stage – the foundations – out of their own pockets. "The cost of this will depend on the house but it is unlikely to be less than £10,000," said Mr Barker.

BuildStore's Accelerator mortgage, funded by Skipton Building Society and BM Solutions, sits at the more generous end of the self-build spectrum. And, unlike N&P, it will also lend in advance of each building stage. The value of the property is assessed in advance of each stage. But again, the amount borrowed must not exceed 85 per cent of what the surveyor thinks the property is worth.

While the downturn may not have affected self-build lending criteria too much on paper, in practice lenders are using more discretion, warns Darren Cook, head of mortgages at financial information provider Moneyfacts. "In the environment of falling house prices, banks are finding it risky enough to lend on homes that are already in existence, let alone against something on which it is not clear what the final value will be. Self-build lenders will be vetting their applicants carefully."

And unless you intend to carry out the work yourself, applicants should be vetting building contractors carefully too, adds Mr Cook. "Building firms are only rewarded at the end of a project and many are folding in the economic climate. The last thing a lender or borrower wants is for the contractors to go under half way through the job."

So it's sensible when employing your builder to bear in mind the old scouting slogan "be prepared". "You should make sure you pay the builder in arrears and in stages rather than up front," Mr Hay says. "This way, if the firm does fold you have not lost out financially and can go to a different one to continue the work. The way the mortgage is designed to assess affordability up front and release money in stages means you should never run out of money during the build."

Fortunately there are plenty of lenders to choose from, an unusual situation in the current credit climate. According to Moneyfacts, 33 banks and building societies still offer specific self-build loans.

Land is readily available too, says Mr Hay at BuildStore. "We currently have 9,000 plots across the UK for sale on our website, compared to a more typical 6,000, as developers sell off land to increase their cash flow. Plots have also fallen considerably in price."

And banks, far from being nervous about the unquantifiable end value of self-build projects, are lining up some prime category borrowers, adds Mr Hay. "As well as having the benefit of a low loan-to-value ratio, self-builder borrowers also tend to be aged between 40 and 50 and financially more settled."

Self-build comes with tax benefits too. Though Stamp Duty is payable on purchase of the land, falling prices coupled with the £175,000 exemption means it rarely applies, says Mr Boulger. Self-builders can also reclaim any VAT paid on goods and materials.

And if a falling housing market is still a sticking point, consider how long the build will take. "If you start to build now the house will be finished around 2010," says Mr Hay, "by which time experts are saying the housing market will be in recovery."

Hayley and Martin Johnson, 24 and 26, from Sheringham, Norfolk, moved into their self-build home a year ago – just in time for the arrival of their first baby, Molly-Anne. "As a gift, my Dad gave us a plot of land next door to a shop he owns and where I also work," says Martin. "We needed a mortgage to fund the build, visited Norwich & Peterborough by chance and discovered the lender was a real expert in the field."

Having the land already, the Johnsons only needed to borrow £72,000 from N&P, which was released to them in seven stages. "But as the funding was in arrears we needed to find the money for the foundations, which my Dad lent us by maxing out his credit cards," says Martin. "My wife's family are in the building trade and also helped us with cut-cost materials."

The risk more than paid off. The completed house – a three-bedroom, detached property with garden – has recently been valued at £220,000. "This puts us in an unusually strong position as first time buyers," says Martin. "We are debt-free, having paid off my Dad, and are left with a £72,000 mortgage which is less than a third of the value of our home. But this would not have been possible without family help."