Loan penalties in the dock

Redemption charges of up to 5 per cent of the mortgage value could contravene new legislation. Dido Sandler reports

REDEMPTION penalties - which are being written into tens of thousands of new mortgages - may be unenforceable under the new consumer protection legislation, a leading City lawyer has warned.

Alexander Leitch, in-house advocate at SJ Berwin, said: "Some of the more onerous mortgage redemption penalties currently being tagged on to new mortgages and remortgages may go against the new requirement of good faith and create a significant imbalance between the lender and the consumer. The redemption charges could be viewed as unfair and therefore null and void.''

It will be up to borrowers to test the new legislation in the courts or write to the Director-General of Fair Trading, who has a statutory duty to investigate complaints about unfair contracts. But if it is proved that penalties contravene the new rules - enshrined in the Unfair Terms of Consumer Contracts Regulations 1994 and introduced on 1 July this year - many borrowers wishing to redeem their mortgages early could be excused from paying thousands of pounds to mortgage lenders.

Since the beginning of the year, borrowers have been locked into mortgages for longer by increasingly heavy penalties for early redemption - the result of a bitter battle among lenders for a diminishing mortgage market.

Most people now buying new mortgages or looking to remortgage before October's change in mortgage benefit rules are being tied in with penalties that make loans so costly to redeem that a drag effect is predicted on the entire market for years to come.

Redemption fees are designed to discourage flight from the current lender to a new one offering more favourable terms. Lenders lure customers with low fixed-rate or discount mortgages. But the customer is made to pay by being locked into the lender's standard variable rate for a given period after the incentive expires

The Halifax, for example, is offering favourable two-year fixed rate deals expiring on 31 August 1997. But it imposes a flat 5 per cent of the total capital advanced - equivalent to around 10 months' mortgage repayments - if the customer pays back the loan before 31 August 2000. All the Halifax's current fixed-rate mortgages make a similar redemption charge.

So if the customer is forced to sell within just three months of taking out the mortgage, and has derived little benefit, he or she will be hit with a bill for 5 per cent of the loan. Similarly, if the customer sells up after four years nine months of the mortgage, having paid at the standard rate for two years nine months, he or she will still be obliged to pay the full 5 per cent penalty.

The Woolwich demands six months' extra interest, plus repayment of any cashback received, from all customers wanting to redeem before time.

The new regulations list a number of potentially unfair terms, including one where the consumer who fails to fulfil his or her obligation has "to pay a disproportionately high sum in compensation". This may not be applicable due to the meaning of the word compensation. But it is up to the courts to develop and expand the concept.

Mr Leitch said when mortgages are redeemed early, not only can the company lend out the money again, but it can receive many months of additional interest repayment or 5 per cent of the advance. This is a blanket charge, and therefore is not adjusted to reflect fairly the loss to the company of the borrower's early redemption.

In deciding the question of ''fairness'', much will depend on the building societies' justification for the penalty.

For example, if interest rates rise during the period of a two year fixed- rate deal, the building society will have made a gain.

The Halifax denies it has a punitive approach. It claims customers are sophisticated enough to know what they are buying into when they take out a fixed-rate mortgage, and that customers with less certain plans for the future are more likely to take out a standard variable-rate loan, with no penalties attached.

Abbey National and Nationwide both support the view that the penalties are made clear up-front, and customers are aware of what they are buying.

The lenders' views are disputed, however, by mortgage brokers working closely with consumers. Ian Darby, marketing director of John Charcol, said: "Most borrowers don't know mortgage redemption penalties exist. And when they are aware of them, they don't think about the impact in pounds, shillings and pence.''

Clive Miers, at Miers Mortgage and Insurance Services in Shipley, Yorkshire, said: "People don't really have the choice. Most of the products being actively marketed at the moment are fixed-rate or discount, to the point where these become the norm.''

q If consumers feel they are facing unfair redemption fees, they can write to the Director-General of Fair Trading at the Office of Fair Trading, Chancery House, 53-64 Chancery Lane, London WC2A 1SP. The Director-General can apply for an injunction if he considers there has been an abuse.