The heavy price of cheap loans

Lenders' plans to scrap mortgage charges may cost dear, says Andrew Verity

Mortgage lenders this week began to debate a wholesale reform of the way mortgages are marketed by proposing changes that could block the sale of a whole swathe of mortgage products.

Adrian Coles, director general of the Building Societies Association, is urging the industry to consider a complete ban on redemption penalties on mortgages with variable rates.

If enough lenders are in favour, the ban could be built in to the Mortgage Code - the voluntary system designed to eliminate sharp tactics in the mortgage market. Home loans which depend on redemption penalties would then struggle to survive.

One major effect, however, would be the end of cashback mortgages. These pay a lump sum upfront which is then added to the loan. The lender locks the borrower in for a set period of years - long enough to recoup the upfront lump sum.

If there were no redemption periods on cashbacks then chaos could ensue: a borrower could switch between lenders at no loss, picking up a tidy cash sum every time. The redemption penalty is usually something like the size of the cashback - up to 5 per cent of the loan.

Lenders would also struggle to offer discount mortgages. These offer a rate up to 1.5 per cent lower than the standard rate: after an initial period of, say three years, the rate rises to level slightly above the normal rate. A lender needs to know the higher rate will last long enough to pay for the initial discount, so the customer is locked in. Early redemptions can cost 5 per cent of the loan's value.

Fixed rate mortgages could still have redemption penalties while the fix lasts. But lenders would be blocked from locking in customers after the fix has ended. This would almost certainly reduce the value of any fixed-rate deals of offer (or, paradoxically, raise the penalties levied on redemptions during the fixed period).

The BSA says the abolition of redemption fees will abolish payment shock - the phenomenon of interest rates doubling as a fixed-rate period ends.

Similarly, many are questioning discounts which offer rates as low as 2.25 per cent for some years. Can customers really plan for the payment shock creeping up on them at the end of the discount period, when rates could quadruple?

Mortgage brokers, however, are vociferously opposed to the BSA's move, accusing it of trying to restrict consumer choice. Andrew Clothier, an award-winning adviser at Torquil Clark, a Wolverhampton-based firm, says: "This would make some mortgage deals much less attractive. I think this is too radical. There's still a very good case for a good cashback. For some people, who have few resources when they start a mortgage, it can mean the difference between getting a mortgage and not."

Industry observers believe the debate on redemption penalties may really be a smokescreen for a much less civilised battle for market share. In a price war described by Brian Davis, chief executive of the Nationwide, as "increasingly violent", many lenders are taking losses upfront in order to get the customers.

Cheap-as-muck fixed rates, cashbacks and discounts effectively gamble the funds of existing members: the borrower has to last a certain amount of time for the lender to make that money back. Redemption penalties are the result. But cheaper fixed and discounted rates can obscure the best variable-rate deals, which building societies believe they beat the banks and other lenders hands down on.

Building societies want to stop banks using tricks like buying new business. Without redemption penalties, they believe the mortgage price war might just swing their way.

But the BSA may run into stiff opposition from banks when the Council of Mortgage Lenders debates the proposals next month. Unlike the BSA, its members include banks and converted societies such as the Halifax. Mike Blackburn, chief executive of the Halifax, has declared his intention to use cashbacks to rebuild its share of the mortgage market.

Moreover, it is not clear whether all building societies would be that keen on ditching fixed-rate and discounted loans. many of them have attracted considerable volumes of business this way in the past two years or so.