Personal finance: Let's all be flexible

The traditional 25-year mortgage has been an endangered species for some time, following radical changes to our lifestyles. But its death- knell was finally sounded this week when a new entrant to the mortgage market pulled the rug out from under the rest of the industry.

In just three weeks, Standard Life's Freestyle Flexibility mortgage has attracted applications worth pounds 500m, nearly half the entire monthly lending of all banks and building societies put together, exploding a few key concepts that the major lenders have resolutely clung to.

The first of these concerns their rigid defence of the way interest is calculated, in the face of consumers' complaints that they are being systematically overcharged. The second is that the mortgages they offer meet customers' needs for flexibility. If only a fraction of the applications being processed by Standard Life mature into loans, the mortgage market will never be the same again.

Its impact was underlined yesterday when Britain's two biggest mortgage lenders, the Halifax and the Abbey National, both disclosed that they are actively developing a similar product, though the Halifax has some reservations. The Nationwide is also examining the scope for further flexibility.

The Woolwich, the first of Britain's mainstream lenders to launch a flexible mortgage, revealed that this is now the first choice of nearly half of all borrowers. The Alliance & Leicester, which recently launched its own flexible mortgage, said it had been "overwhelmed" by the response.

The reason these mortgages are popular is because they allow borrowers to overpay in the good times, and underpay, or not pay at all, when life gets tough, without having to crawl on bended knee to their bank manager. Insecurity at work, and the increase in contract and casual employment, make this a vital facility for many.

But for really effective flexibility, interest on these mortgages has to be calculated quite differently from the current method. This has serious implications for computer systems and the finance industry.

Building societies and traditional mortgage lenders have always worked out interest annually. At the beginning of the year they calculate your monthly repayments and your balance remains unchanged until the end of the year, when they do the sums again.

However, when interest is calculated monthly or daily your balance falls during the year, as you make repayments, and your interest bill falls with it. This is particularly important if you wish to overpay, because you will be given credit for this immediately; it may save you thousands of pounds.

Standard Life, which calculates interest daily, estimates that a borrower can slice pounds 2,200 off an pounds 80,000, 20-year mortgage by calculating interest daily rather than annually. A staggering pounds 12,000 can be saved by upping the repayment by pounds 50 a month. Traditional lenders have always fiercely denied that annual calculation costs borrowers more, but there are signs that their defences are beginning to crack.

Alliance & Leicester's mortgage marketing manager, Jeff Sutherland-Kay, is convinced that it is only a matter of time before all mortgages offer flexibility and the choice of monthly rather than annual interest. He says: "Every lender in the country is looking at launching a flexible mortgage, because we know that's what customers want. The world has changed. People no longer wish to make the same repayment over 25 years. They want to pay off more in the good times and less in the bad times, and for their overall interest bill to be cut accordingly - and that means monthly interest.

"I have no doubt that, over time, every mortgage product in the mortgage portfolio will offer this potential, but in the short term there are chronic computer system problems."

The mortgage brokers John Charcol are less sanguine about lenders' motives for sticking with annual interest. A spokesman, Ian Darby, says: "The thing that's holding them back is the cost. There will be one hell of a price to pay if the mainstream lenders are forced into flexibility. If the traditional lenders start charging interest on a monthly or daily rather than annual basis, their balance sheets will take a hammering. We are talking tens of millions of pounds."

In his view, it was the Woolwich initiative that broke the mould: "For the first time you had a mainstream lender offering a competitive range of mortgage options with the flexibility to over- and underpay, and interest charged monthly."

But the Halifax points out that while monthly charging can work in a customer's favour when he is repaying early, it has the opposite impact for borrowers with difficulties.

A spokesman says: "Don't forget, if interest is adjusted monthly or daily, the arrears will climb faster as well."