The Subvention Scheme Trap

Real estate investments are known for fancy financing schemes. The right financing can make any real estate investment very lucrative whereas the wrong financing can end up giving disastrous results. Real estate developers have started using several different types of financing schemes to woo wary home buyers in the time of an industry slowdown. One of these schemes that are being extensively used is called the subvention scheme. A large number of first-time buyers are using this scheme to acquire their dream home. However, they are not aware of the many pitfalls of this type of financing.

In this article, we will explain how the subvention scheme has the potential to entrap prospective home buyers and cause grave financial harm to them.

Difference Between Subvention Scheme and Construction Linked Payments

In case of subvention schemes, the buyer pays the margin money. The bank disburses the entire loan amount and credits it to the developer on the very same day. The developer gets paid in full at the very same time! In return, the builder agrees to pay the interest accrued on loan to the bank on behalf of the borrower. Hence, the entire money is received upfront by the developer whereas the buyer owns nothing more than an agreement.

On the other hand, construction linked payment plans are when the developer is given fixed sums of money on the completion of certain milestones, i.e., slabs. The way these payments are defined can have a huge impact on the behavior of the builders. If the majority of the payments are given before possession, it is likely that the builder will delay possession. However, a lot of construction linked payment plans give a lot of weightage to possession and close to 25% of the payment is released after possession is provided by a builder.

Why Are Builders Pursuing Subvention Schemes?

It is absurd that builders are resorting to borrowing money on account of individuals even though businesses are given money at a lower rate of interest. Mainly the real estate business has assets that can be mortgaged to unlock the cash required to complete the project. Hence they should have access to credit at a lower rate than individuals.

However, it needs to be understood that most developers have heavy debt burdens. Their balance sheets already carry a lot of debt. Banks are not willing to offer more debt until they charge a very high rate of interest. It is therefore in the interest of the builder to borrow money on account of the buyer. The bank will not give the builder a lower rate of interest. However, they may offer the same to buyers depending on their credit rating.

Developers are not opting for subvention schemes. They are being forced into these schemes by banks who wouldn’t lend out to them. The question that arises is, if banks think it is too risky to invest in these real estate projects, then why is it that individual buyers think otherwise.

Maybe, the whole concept of subvention schemes is based on the ignorance of the individual home buyer.

Disadvantages

Some major disadvantages of the subvention scheme are as follows:

  • No incentive for timely completion: Once the builders receive their payments, they don’t have any incentive to complete the work on time. This is particularly true in case the builder has agreed to pay interest only for a specific period. After the period lapses, the builder stops making payments regardless of whether or not the possession has been given to the buyer. The subvention scheme gives an unfair advantage to the developers while jeopardizing the interests of the buyers.

  • Diversion of funds: It is extremely likely that the builders will divert funds received on account of one project to another project. Such diversion of funds is not ethical. However, there aren’t any laws preventing this from happening. These diversions allow developers to start multiple projects simultaneously even though they are not able to complete any of them on time. Individuals bear the cost of delay.

  • Buyer’s credit rating: In case, the developer stops making payment to the bank on account of the loan, their record is not affected. The loan shows up on the borrower’s personal account. As such builders do not have to pay these loans or their account, they are not their priority. As a result, they often delay or even default on these loans. The negative effect of their reckless actions is borne by the buyer’s credit rating. The credit rating of the buyer can take a severe fall thanks to the subvention scheme.

  • Lack of exit options: Since the entire scheme is riddled with problems, not many buyers prefer the subvention scheme. It is for this reason that the few buyers that do prefer this scheme have limited to no exit options. This makes this an illiquid investment that devours a significant amount of cash and poses a great risk to the owner. It is for this reason that subvention schemes are considered harmful to the financial health of the buyers involved.

The best way to buy a home is to avoid these complicated financing deals. Good old-fashioned financing has been tried and tested for decades and provides a fair opportunity to both parties involved.


❮   Previous  Article

Authorship/Referencing - About the Author(s)

MSG team comprises experienced faculty and professionals who develop the content for the portal. We collectively refer to our team as - “MSG Experts”. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.