UK mortgages `are overpriced'

British lenders' margins are twice as high as those on the Continent, w rites John Willcock

British banks and building societies charge margins on mortgages that are on average twice as big as those levied by their Continental equivalents.

However, due to overcrowding in the UK financial markets and the intense competition that this leads to, margins on mortgages are likely to fall in the coming years.

Put crudely, many banks and building societies could still be making reasonable profits if they charged £50 per month less for an £80,000 mortgage. That is the difference between charging a 2 per cent margin, a rough industry average, and the 1 per cent margins more common on the Continent.

The mortgage margin is the interest charged by the lender above the cost to the bank or building society of raising the funds, either from its own depositors or from the London money markets.

Most banks and building societies have just raised their normal floating mortgage rates to over 8.5 per cent in reaction to the December base rate rise. According to recent research by Merrill Lynch, the American securities house, rates could have been limited to 7.75 per cent.

It is difficult to explain precisely why this disparity has arisen. Much is due to the fact that building societies have to offer attractive rates to their depositors to attract the funds that they then lend out in the form of mortgages. Societies have been loath to lose this form of "cross subsidy".

Also, the UK banks and building societies have traditionally tended to move together, and while they do not actually fix the prices between them, increased competition has not yet been translated into a mortgage price war.

The report by Merrill Lynch, written by Ian McEwen, first vice-president, and Abigail Leach, industry analyst, says: ". . . relative to risk UK variable rate mortgages are very much overpriced. The beneficiaries of this overpricing are, of course, the building societies and banks themselves - but also to some extent the retail depositors of the building societies, who in effect have a service that is subsidised by the societies' borrowing members."

The good news is that Merrill Lynch expects mortgage margins to fall. The report points to the entry into the market of aggressive new lenders like Direct Line, the Royal Bank of Scotland subsidiary. When it was launched, Direct Line started offering mortgages that undercut its parent bank by a full 1 per cent.

Similarily, Bank of Scotland Mortgages Direct is charging lower rates than its parent bank, again because it does not have to cover the costs of running a branch network.

The proposed merger of the Halifax and Leeds building societies and their proposed conversion into a bank removes the building society industry's flagship. The new business will provide a full range of financial services, which Merrill Lynch thinks will lead to a decline in cross-subsidies. This will be another force driving mortgage margins down.

Sadly the practice of trying to confuse new mortgage customers with fancy-sounding discounts, and disguising the real long-term costs of a mortgage, will probably continue.

The Merrill Lynch report says that providers of such discounted schemes, which might offer a big chunk off interest rates for the first two years, still have to cover their costs. This means that the lenders must get the borrowers on to a higher variablerate and keep them there for a number of years in order to make money on the mortgage.

They do this through high penalty charges for getting out of the mortgage, of up to three months' interest payments. The flashy discounts or cash-back offered in the first few years distract the customer from the fundamental price of the mortgage over the whole of its life.