Oct. 9 (Bloomberg) -- Stuart Heathcote and his wife never intended to buy a house this year. Then the U.K. government offered an incentive that changed their minds: a no-money-down mortgage.

It was just the head start they needed to sign a contract for a 135,000-pound ($216,000) three-bedroom house near Birmingham, the country’s second-biggest city. Stuart, who works for the National Health Service, and his wife plan to move in before the end of January.

Easy credit is back in the U.K., and this time the government and homebuilders are making the loans. Seeking to recover from the worst recession in a generation, Britain is helping as many as 10,000 buyers obtain 100 percent financing through a 300-million-pound plan called HomeBuy Direct at a time when mortgages are scarce and, according to Ernst & Young LLC, home prices will “stagnate” for at least two more years.

“It’s a catastrophe waiting to happen,” Robin Hardy, a homebuilding analyst at KBC Peel Hunt, said of the plan. “If the only way a certain bit of the market can work is to lend deposits, those people can’t afford a house. It’s being done for the industry and not for the first-time buyers.”

More than 32,000 potential homebuyers have sought information about the loans, a sign that borrowers aren’t scared off by a home price drop accompanied by rising foreclosures and defaults on high percentage loans that outstripped values. There are currently no plans to expand the plan.

‘Decent Success’

Britain’s homebuilders have also embraced HomeBuy Direct to revive sales. Barratt Developments Plc, Persimmon Plc, Miller Group Ltd. and Redrow Plc are offering a combined 7,000 homes through the plan, according to the companies.

“Generally, it has been very good for the industry,” Chris Millington, a house building analyst at Numis Securities in London, said in an interview. “It removes one of the main problems in the market and helps the new buyer. It has been quite a decent success.”

The financial crisis forced every major U.K. mortgage provider to stop making loans for 100 percent or more of a home’s value by April 2008. Home prices will fall about 30 percent from their October 2007 peak, Fitch Ratings said on Oct. 7, confirming an earlier forecast. Prices are currently down 13 percent from that level, Fitch said.

When property prices decline, homeowners with higher percentage mortgages are more likely to fall into negative equity, where the loan is greater than the value of the house. More than 270,000 mortgages were in arrears for longer than three months as of the end of June, according to the Council of Mortgage Lenders. That’s the highest level since June 1997.

Seeds of Slump

“One hundred percent loan-to-value mortgages were what partly got us into this mess in the first place,” said Paul Guest, head of research for Europe the Middle East and Africa at Jones Lang LaSalle Inc. “I would be concerned with the message this sends to borrowers.” Guest was previously chief European economist at Moody’s Investors Service.

To qualify for HomeBuy Direct, borrowers must have a good credit history, no rent arrears and have no breaches of their current rental agreement, according to the government brochure for borrowers. It didn’t cite a specific credit score needed to qualify.

The loans are interest-free for the first five years before starting at 1.75 percent and rising annually by a level linked to inflation. The plan reduces the chance of negative equity because the amount owed to the government and developer will fall if the value of the home declines. If the property’s value has increased when it’s sold, the state and homebuilder will share in the profit based on the size of the loan.

Property Ladder

“HomeBuy Direct is giving thousands of first-time buyers the chance to step onto the property ladder,” Communities and Local Government, the department overseeing the program, said in an e-mailed response to Bloomberg. “This is not a 100 percent mortgage -- the buyer gets a mortgage for up to 70 percent of the property’s value. The remaining 30 percent is made up by an equity loan, co-funded on equal terms by government and housebuilder, and free of charge for the first five years.”

The plan convinced Heathcote, a 33-year-old information technology specialist, to buy a house rather than rent. He and his wife, who together earn about 40,000 pounds a year, chose a house in a development called The Keep built by Persimmon.

“We didn’t have any desire to buy really,” said Heathcote. “Five years down the line, we may have been able to put down a deposit for a place, so this is like a head start.”

Homeowner’s Burden

KBC’s Hardy, who has more than a decade of experience with the U.K. homebuilding industry, said the program is burdensome for homeowners. A first-time buyer of a 130,000-pound home under the plan would have to save about 650 pounds a month on top of mortgage payments to pay off a 30 percent loan of 39,000 pounds in five years, he said.

“Every scheme in history the government has tried to implement in the housing market has gone completely toes up,” said Alastair Stewart, a London-based analyst at Investec Securities. “It perpetuates the high prices. The best way to increase demand is to let homes fall back to their natural prices.”

U.K. homebuilders are calling the plan a success and some have initiated their own lending plans such as Barratt’s Head Start, Bovis Homes Group Plc’s Jumpstart and Taylor Wimpey Plc’s Easystart.

Real Momentum

“HomeBuy Direct has now got real momentum,” Mark Clare, chief executive officer of Barratt, said on a Sept. 23 conference call. “It’s really beneficial for the first-time buyers and a low-cost way to ensure other people can participate in the market.”

Around 800 properties have been bought or are close to being purchased through the plan, Clare said.

“It’s an excellent move by the government,” Keith Miller, chief executive officer of Miller, Britain’s largest closely held homebuilder, said in an interview. “In times like these, it helps to get the bottom end of the market moving, and these people are very carefully qualified.”

Around a quarter of Persimmon’s sales and one-fifth of Barratt’s came from shared equity plans in the first six months of the year, the companies said.

Kirsten Johnston, 30, was accepted for a HomeBuy Direct loan, then withdrew from the plan after two banks turned her down for a mortgage. Johnston, who works for RWE npower, a gas and electricity supplier, said she was unable to persuade the second lender, Royal Bank of Scotland Plc, that a county court judgment on her credit record should have been removed in 2007.

Plans Ditched

Johnston and her sister, who have combined income of 40,000 pounds, had planned to buy a 175,000-pound house at the Windsor Heights development in Redditch, central England.

“Although these banks say they’ve bought into the scheme, they don’t want to deal with shared equity arrangements, so they’re making life difficult,” she said. “I intend to move in with my sister and save hard for a deposit. I gather that some banks will do 95 percent mortgages.”

The number of U.K. loans for house purchases rose 24 percent in July from the previous month to 56,000, the Council of Mortgage Lenders said on Sept. 14. Still, the Bank of England’s data on mortgages show the number of approvals is less than half the total in the same month two years ago.

Less Disastrous

Rachael Waring, an analyst at Panmure Gordon in Liverpool, said the government plan isn’t simply a return to the no- deposit lending of the past.

“They are borrowing their deposit, but at more attractive rates and with the government security behind them, so it’s not as disastrous as a traditional 100 percent mortgage,” she said.

HomeBuy Direct loans will be available until the end of March. By then, the Heathcotes should be in their new home in Darlaston, about 10 miles (16 kilometers) from Birmingham.

“We’re going to live here for at least 10 years,” said Stuart Heathcote. “Now we have enough space for when we start a family.”

To contact the reporter on this story: Tim Barwell in London at tbarwell@bloomberg.net

Last Updated: October 8, 2009 19:01 EDT