When your bank has you under house arrest

It is autumn 1997 and the cost of home loans has increased nearly every month since the Labour government was elected in May. Talk in the City is of economic slowdown and job losses. House prices, meanwhile, have been roaring ahead. In some parts of the country it is difficult to buy a tiny flat for less than ?100,000, let alone a family home. If you are thinking of taking out a ?100,000 loan, the knowledge that payments will not rise for the next 15 years has its attractions, and NatWest Bank is there to oblige with fixed deal over this period at 8.59 per cent.

If you were that borrower you will, less than a year and a half later, be feeling somewhat queasy. The country's largest mortgage lender, Halifax, is charging 6.95 per cent for a standard variable mortgage, a deal with no strings, but no edge on rates either. Among the 2,000 or so deals on the market, some boast rates as low as 3 per cent.

So the obvious answer is to remortgage, right? Not so fast. The NatWest deal carries a penalty for early redemption that rises when interest rates fall. The fall in market rates has been so hard and so fast, that the cost to that 15-year borrower will be ?43,500 - enough to buy a home outright in some areas. Yet when a borrower with such a deal approached mortgage broker John Charcol, the best saving to be achieved by remortgaging was ?32,000.

This is an extreme example of the mortgage penalties that have caught out borrowers on fixed rates as interest rates have plunged. 'If you had asked a representative sample of economists three years ago what the base rate would be now I would be surprised if they had said 5.5 per cent,' says Ray Boulger, technical manager at Charcol.

NatWest says it will negotiate over its redemption charges, which even the bank admits have turned out to be steeper than it expected. The penalty rates are known as market-to-market charges, and are calculated by deducting the going rate in the wholesale money markets - where banks raise fixed-rate funds - from the rate on the fix, and multiplying the difference by the number of years left to run on the deal.

Barclays imposes similar penalties on some of its fixed-rate loans, and confirmed last week that someone with a ?100,000 loan fixed at 7.99 per cent until 31 January 2008 would have to pay ?18,000 to get out.

Borrowers are now at the mercy of banks if they want to jump ship. Lenders impose such penalties because, they argue, they have to pay for the fixed-rate funds at the higher rate, so lose if a borrower bails out early. Both banks defend penalties as necessary to cover their costs, and claim they are fairer than other systems in the market.

NatWest says that if the charges work out at more than the bank needs to cover the cost of redeeming the fix, it reduces the penalties accordingly. However, head of sales and marketing David Strange says the most it can usually reduce them by is 15 per cent. The magnitude of these penalties leaves those caught out feeling as though they have fallen victim to another financial services scandal. The Office of Fair Trading confirms that it has received a complaint about redemption penalties on a NatWest loan, and may act under Unfair Terms in Consumer Contracts Regulations, 1994, enacted under a European Community directive. The OFT is also looking into a complaint about another lender's penalties.

Mortgage brokers say it may be difficult for borrowers to make a case, however: they would need to prove that the penalties were not made clear to them. Says Boulger: 'It is uncomfortable. But the most important thing is whether people were aware of the penalties when they took out the mortgage.'

While the NatWest and Barclays penalties are too swingeing to make remortgaging worthwhile, the outlook is better for many other borrowers on fixed-rate deals, even if the get-out costs run to several thousand pounds. This is because there are now deals available at such low rates that it pays the borrower to move.

The pain for these people may also be dulled if they have been paying less than the standard variable rate for around a year. This has nudged 9 per cent with the high street banks. Also, the cap on borrowing costs may have provided security at a time when many businesses have been cutting jobs.

Boulger says: 'There are a lot of people whose key reason for taking out a fixed rate is stability. Some people will take a view that even if they end up paying a bit more, it is a price worth paying for peace of mind.'

This is likely to be particularly true of borrowers who lived through the early Nineties, when mortgage rates topped 15 per cent. A rate of 7 or 8 per cent may seem expensive now but the borrower will, presumably, have budgeted for that cost. Unexpected increases in rates can lead to repossession.

And, despite the disappointment at having been outwitted by the economy, some borrowers with fixed rate deals will still emerge as winners by switching to a lower rate.

The difficulty for borrowers in the past few years has been trying to second-guess the British economy. Its history of high and volatile home loan costs has left many wary of floating rate mortgages, even though the general trend was known to be downwards. On the Continent, where fixed rates are popular, rates generally have been lower and more stable than in the UK.

But have UK borrowers paid too high a price for their fixed-rate security? In the US, it is possible to fix your loan without a redemption penalty, although borrowers do pay upfront fees. And there are signs in the UK that, under pressure, lenders here can do better for borrowers seeking fixes. Deals without penalties are starting to appear. One example is the 4.99 per cent three-year fix from Leeds & Holbeck building society.

Lenders have come under attack not only for hefty redemption penalties, but also for penalties that outlast the period for which a fixed or discounted deal applies. Many people are now paying standard variable rates, but because they face redemption penalties for another year or more, a remortgage will not save them money.

Despite widespread criticism, many such deals are still available and tend to carry the lowest 'headline' rates of interest.

Mortgage broker Clive Miers believes they will remain a feature of the mortgage market because for lenders they are a way of making a profit.

'If borrowers don't think about moving because of penalties, it is a way of surreptitiously creating customer loyalty,' he said.