A loan that's too good to be true

Homeowners who put down less than a 10 per cent deposit to buy their house are being penalised by hundreds and often thousands of pounds in order to protect the lender in case they default on repayments.

According to financial data provider Moneyfacts, three quarters of the 120 mortgage lenders in the UK apply a higher lending charge (HLC) to loans that are anything over 90 per cent, or in some cases over 75 per cent, of the value of the property.

An HLC will buy the lender insurance cover to protect it from loss should a borrower fail to meet their repayments. The lender does this on high loan-to-values because where defaulting borrowers have put down only a small deposit, there is less chance the lender will be able to recover the money it lent when it sells the repossessed property.

The HLC, which is typically about £1,500, offers no protection to the borrower - the lender's insurer can pursue you for the money it has had to pay out to the lender even after your home has been repossessed and sold off.

Even more infuriating for home buyers, now that house prices seem to be on the rise again, the insurance is unlikely to be called on. There is little chance that the lender will not recover its money.

'With either a rising or a stable property market being the norm in the UK in recent years, it would be interesting to know how many claims have been made against what appears to be a somewhat outdated form of insurance,' says Rachel McKay, the assistant head of mortgages at Moneyfacts.

The Nationwide building society, which is among the handful of lenders that don't charge HLCs, estimates that more than 800,000 homebuyers have paid this charge in the last five years, and 500,000 of them were first-time buyers. On top of the charge, some lenders such as the Halifax and Abbey charge higher interest rates for those borrowing higher loan-to-values.

'Higher lending charges are never justified,' says Melanie Bien, the associate director of brokers Savills Private Finance. 'This is an out-of-date practice that many lenders have now ditched, so if you do need to take a high loan-to-value, opt for a lender who doesn't charge an HLC.

'If you really have no choice but to opt for a lender charging an HLC, try to borrow the money from parents or family to enable you to put down a bigger deposit and avoid paying the charge.'

Simon Tyler of broker Chase de Vere Mortgage Management agrees: 'The higher lending charge is probably the most controversial - and costly - fee levied by mortgage lenders. However, because in many circumstances it can be added to the loan, and because people are simply not very adept at identifying the best deal for their circumstances, far too many borrowers still pay the charge when they would be better off with another lender.

'Not many people realise that the HLC can be so expensive that very often they would be better off paying a significantly higher rate and avoiding the HLC than going for the cheapest rate and shouldering the cost.'

The costs of a HLC can often run into thousands of pounds. For example, someone putting down a 5 per cent deposit on a £150,000 property might think they would be better off taking a two-year fixed-rate mortgage from Portman at 4.15 per cent than Bristol and West, which charges 4.49 per cent. Monthly repayments would be £28 cheaper with the Portman deal - a saving of £672 over the two-year period. However, Portman charges an HLC, which in this scenario would cost the borrower £2,550. This would mean they would be £1,878 better off avoiding the HLC and paying the higher rate with Bristol and West.

If you do have to pay an HLC you will also be better off paying it up-front if possible. When you add it to the life of your mortgage, you pay interest on it. The charge is typically applied to the sum of money you borrow above 75 per cent of the value of your house - so if you buy a house for £100,000 and borrow £95,000, the charge will be applied to £20,000 of the loan. It is generally set at 7.5 per cent, so in this case would cost the borrower £1,500.

However, if you borrow a 100 per cent loan-to-value, then the charge can rise considerably. The Bank of Scotland and Yorkshire Building Society, for instance, charge 12 per cent of the cash value between 75 per cent and 100 per cent, thereby costing £3,000 for a borrower buying a £100,000 property.

Moneyfacts identifies 33 lenders that do not impose an HLC. These include Nationwide, Northern Rock, C&G, Egg, HSBC and the Co-op.