Don't get stung by penalties

Some mortgage deals look great on paper - but beware lengthy and expensive tie-ins, says Stephen Pritchard

Take out a mortgage and you could drive away with a brand new car. This is the current deal from the West Bromwich Building Society, which is offering a free Rover 25, as long as homeowners borrow at least £90,000. The catch, though, is that they have to keep their mortgage with the society for five years, paying the West Brom's standard variable interest rate. Pay off the mortgage or switch to another lender, and you will have to pay a penalty of seven per cent of the loan, up to a maximum of £7,000.

Take out a mortgage and you could drive away with a brand new car. This is the current deal from the West Bromwich Building Society, which is offering a free Rover 25, as long as homeowners borrow at least £90,000. The catch, though, is that they have to keep their mortgage with the society for five years, paying the West Brom's standard variable interest rate. Pay off the mortgage or switch to another lender, and you will have to pay a penalty of seven per cent of the loan, up to a maximum of £7,000.

Other mortgages have similar stings in their tails. Britannia Building Society's 10-year fixed rate mortgage has a redemption penalty of 360 days' interest, based not on the fixed rate itself (5.49 per cent) but on the lender's standard variable rate. This is currently 6 per cent.

Such deals, however, are less common than they were even two or three years ago, as pressure from consumer groups and competition has forced lenders to move away from expensive penalties and long-term tie-ins.

In particular, mortgages with extended penalties, where a borrower is tied in after a discount or fixed rate ends, are now relatively few and far between. "Most penalties are now capped at six months' interest," says Pat Bunton, a director at the broker London & Country Mortgages. "Higher penalties usually come with the longer-term fixed-rate loans. But we do not recommend deals where the penalties last beyond the incentive period."

Elliot Nathan, mortgage development manager at Bradford & Bingley, agrees. "I can't see a good enough reason for taking a deal with extended tie-ins unless the interest rate throughout is competitive - and this isn't usually the case," he says.

A homeowner might, however, accept a long tie-in as a trade-off for a long-term fixed rate, because they benefit from the certainty that comes with such a mortgage. And although mortgage experts shy away from recommending deals with an overhanging penalty, they can suit some borrowers. "My sister took a mortgage with an overhanging penalty because she wanted a low initial rate while she was on maternity leave," Bunton explains. "She wanted to minimise her payments for two years, and was prepared to pay the higher, standard variable rate in return."

Bunton points out that if lenders are forced to cut all deals with heavy penalties, some borrowers will lose out because there will be fewer deals to choose from.

There have been suggestions that the Financial Services Authority will "ban" some mortgages when it takes over regulation of the market in October this year. However, a spokesman for the FSA insists that it will not prevent lenders from selling the deals they want to, but will demand transparency of information and correct information disclosure.

Existing consumer credit and contract laws do prevent lenders from offering loans with terms that are unfair. In theory, a mortgage with extended penalties or penalties that cannot be known at the point of taking out the loan could be ruled as unfair by the courts. But borrowers would have to resort to legal action to determine this.

Borrowers will only be able to complain to the FSA if they believe they have been mis-sold an inappropriate loan, or if key terms were not disclosed to them.

Until then, the onus is on borrowers to do their research carefully. Nathan points out that mortgages with very low initial rates and overhanging penalties do appeal to homeowners arranging loans over the internet, where there is no advice, but very few people sign up for these deals once an adviser has illustrated the full costs.

And even if a deal looks great on paper, further examination may prove that it is not. Bunton explains that the West Bromwich "free car" mortgage might make sense for someone borrowing the minimum, £90,000 mortgage available under the deal. With a "street price" - according to the lender - of £9,000, the Rover 25 represents a 10 per cent discount. However, borrowers who want larger loans are not offered a more expensive car by West Bromwich, so effectively they enjoy a smaller discount. The buyer must, as always, beware. "The adverts are not going to say that this is not as good a deal if you want to borrow £180,000," Bunton says.