When the lenders don't play fair

Borrowing is one of the many things in life that is easier to get into than out of. And the early redemption penalties that feature in many mortgage agreements don't help anyone who is looking for the exit.

These penalties are designed to deter borrowers from repaying the loan before a lender has had the opportunity to earn a hefty profit on the interest payments.

With fixed rate mortgages it is hard to argue that there is anything wrong with these clauses. Both borrower and lender know the exact cost of the loan. It is where the lender reserves the right to change the rate or levy new charges, while the borrower cannot go elsewhere, that problems arise.

A glance through Jobs & Money's Capital Letters pages over the past few weeks highlights some of the issues. At least one reader is threatening to take Britannic to the ombudsman after it increased the legal fees it charges on redemptions from the £125 he had been promised when taking out the loan to £225.

Many financial institutions take a "we can do what we like, because our small print says we can" approach to their customers. However the law is rarely on the side of businesses which do that. The most important restriction is the Unfair Terms in Consumer Contract Regulations, first introduced in 1995 and revised in 1999. The financial services industry lobbied hard to be excluded from their effect. The government though did not accept the industry's claims that it was capable of self-regulation, a view that has been vindicated by the series of scandals that have dogged it ever since.

The basic rule is that unfair terms are ineffective. If a mortgage or loan agreement allows the lender to change the rate, even for a good reason, the borrower should, if a term is not be unfair, have the right to terminate the agreement.

Changes to the interest rates in line with base rates will always be considered fair, but the customer may still have the right to end the agreement.

The courts have rarely considered this provision. In an action by Abbey National against a Mr Wright at Kingston County Court it was considered fair for a lender to require borrowers to continue paying a standard rate for long enough to enable it to recoup the loss caused by an initial low rate.

That standard rate was however calculated with reference to official base rates. The Financial Services Ombudsman soon afterwards considered another Abbey National mortgage in a claim brought by a Mr and Mrs G. He considered it was unfair for borrowers to be tied in to a rate that didn't have that official tie-in but fluctuated by a mere 0.25% higher than most other lenders were offering. His decision was based on the fact that borrowers have a "legitimate expectation" that lenders will continue to offer them competitive products. Once the Abbey started charging more than other lenders, it had not lived up to the expectation and borrowers could not be tied to the higher rate.

The ombudsman's decision did not actually follow the language of the regulations very closely, nor is it legally binding. Nonetheless it adopted a common sense approach that might be taken by many courts.

In a similar vein, the OFT issued guidance in February 2000 that locked in borrowers should not be forced to bear worse conditions than those which were being offered by the lender to new borrowers.

A lender attempting to vary its rates also has to show that the reason for doing so is one specified in the contract. The vaguer the expression used, the less likely it is to be effective. A right to vary charges "In accordance with our policies" or the even more Orwellian "to reflect our customers' ever changing needs" will not work.

In the example of Britannic, it's claim that its charges should be increased because they were too little compared with what others charged is hopeless. To allow it to offer a highly competitive rate to capture lenders, and then withdraw it once they cannot escape, would defeat both the letter and spirit of the regulations.

· Richard Colbey is a barrister