Pesronal finance: The cost of cut-price mortgages

Discounts, fixed rates, capped rates, the permutations of cut- price mortgages seem endless. Lenders want you to borrow. But where the incentives are very attractive, is there a catch?

Lenders can no longer require you to take life insurance and savings policies with the insurer of their choice. Existing policies should be fully transferable when you move from one lender to another.

But this does not apply to buildings, contents or accident, sickness and unemployment (ASU) insurance. None of these is covered under the best advice clauses of the Financial Services Act. As a result, buying one or more of these types of cover from a lender can be made a condition of qualifying for a discount loan.

Because these products are not sold on the "best advice" basis governing the sale of life products, lenders are not obliged to find you the cheapest cover available.

Of course, discounted and fixed-rate loans are still available if you insist on finding your own insurance, but you must expect to incur interest rate increases of between 0.25 per cent and 0.5 per cent on the cost of money borrowed.

Take buildings insurance as an example. This covers the re-building cost of the property to be purchased, which usually exceeds the market value by a factor of up to 50 per cent. Standard cover includes an accidental damage clause, against factors like fire and flood.

Premiums for building insurance can vary massively. Asked to quote on identical terms - a flat in Edinburgh with a rebuild cost of pounds 200,000, AA Insurance Service came up with an annual premium of pounds 59.72. Meanwhile, National Direct quoted an annual premium of pounds 215.28, and Newcastle Direct a premium of pounds 403.44.

Both of these premiums were quoted as part of fixed-rate packages; Nationwide offered a 1.8 per cent discount off their SVR, equalling 6.3 per cent for three years, and Newcastle 5.99 per cent fixed for three years. Other lenders like Woolwich, and Abbey National quoted at least pounds 350pa while the mutual Skipton BS came top, quoting a premium of pounds 474.60 a year, again as part of a discounted loan.

Accident, sickness and unemployment policies are becoming more popular with lenders. Several offer them along with house or contents cover on the basis that borrowers must choose two out of three of these policies to qualify for a discount mortgage.

According to Ray Boulger, of mortgage broker John Charcol, "In almost all cases, anyone under 40 can find cheaper ASU cover either direct from an insurer like ITT London & Edinburgh, or from a mortgage broker."

At least one reason why lenders make these types of insurance compulsory are the levels of commission their receive, which can amount to as much as 40 per cent of premiums paid over the policy term.

Redemption penalties also apply to these loans, but the basis for charging can differ widely. Some apply a fixed percentage of the amount borrowed. As a general rule, the greater the incentive, the greater the penalties of redeeming a loan before the set period.

According to Mr Boulger, anyone tempted by a special deal should look closely at the small print. "Avoid redemption penalties that last longer than the discounted or capped rate on offer. That way, you are free to look for another deal when the first one runs out."

Take Scarborough BS, currently offering a one-year fixed rate loan at just 1.25 per cent. A redemption penalty fixed at 7.19 per cent of the amount borrowed applies for the first five years of the loan. After the first 12 months, this loan reverts to Scarborough's SVR of 8.69 per cent, currently 0.2 of one per cent above the average charged by major lenders.

Most such redemption penalties are set at 5 per cent of the amount borrowed, but for those contemplating partial early repayment, care is needed, as the penalty is set not on the outstanding balance at the time of redemption but the full amount for borrowed.

Early redemption penalties are avoidable, but only if you remortgage with the same lender, borrowing the same or more. Most will charge the penalty, then pay it back as a credit, reducing the amount of the new loan. But purchase of your new home will have to be completed within three months of redeeming your first loan to qualify.