In its pre-election manifesto, the Government said it would work with mortgage providers to encourage flexible mortgages - home loans that allow customers to vary repayments as their financial circumstances change.
But lenders say the Government is now threatening the survival of the products because of over-zealous regulation by the Department of Trade and Industry that will make them far too expensive.
Typically, a flexible mortgage allows customers to overpay, build up a surplus and then draw down on the mortgage account when times are hard or extra capital is needed.
Kim Howells, junior minister for competition and consumer affairs, last week wrote to lenders confirming they must treat each draw-down as a separate loan under the Consumer Credit Act, prompting a furious reaction.
The Council of Mortgage Lenders warns that the Government's stance will load bureaucracy on to the products, increasing administration costs and interest rates. They say it could even make some of the loans unenforceable.
Under the Consumer Credit Act lenders are forced to issue two 20-page long documents when they offer a loan, before and after a seven-day cooling- off period in which they cannot advise the borrower. If so much as a comma is missing from the prescribed documents, the loan falls outside the law and lenders cannot force borrowers to pay the money back. As a result, regulated loans typically cost twice as much in interest as mortgages.
Stephen Knight, chairman of the Independent Mortgage Collection, said: "We were looking at launching a flexible mortgage and we have put that on ice because of this issue. The whole point of them is that you can pay more in times of feast and get money back in times of famine. If each draw-down payment has to be sold as a regulated loan, flexible mortgages will disappear overnight."
A spokeswoman for the Council of Mortgage Lenders said: "There is a risk this could squash flexible mortgages. There is no question - it makes it much less attractive for lenders to offer it and much less attractive from the consumers' point of view."
If the Government's view is right, holders of some existing flexible mortgages who have drawn out money will, on a strict interpretation of the law, be able to avoid repaying it.
Lenders are now engaged in a legal battle with the Government and have commissioned legal advice from barristers who contradict the Government's stance.
They say the Government's stance will also block its own policy objective of encouraging flexible loans.
Hillary Armstrong, another junior government minister, said in June: "Home buyers need more flexibility with their mortgages to cope with gaps in income. Mortgages which allow over-payments during good times and under- payments, or payment holidays, when finances are tight can be of great help."
Suppliers of flexible mortgage products, some of whom insist their loans are unaffected by the debate, include Virgin Direct, Woolwich, Legal & General, Scottish Widows and First Active.
Many are angry at what they see as a misguided attempt to protect consumers from themselves.Reuse content