THE OFFICE of Fair Trading yesterday warned banks and building societies they may be breaking key rules designed to stop them stacking the terms of mortgage contracts against consumers.

In another damaging blow to the image of the mortgage lenders, the OFT said it was increasingly concerned that lenders were giving themselves complete discretion to vary interest rates while borrowers are locked into a mortgage.

Potentially, the warning could be followed by a full inquiry that concludes the lenders are breaking regulations on Unfair Terms in Consumer Contracts. With a stroke of the pen, the OFT could insist the contracts be changed, in effect removing a whole swathe of mortgage products from the market.

The concern is focused on fixed-rate loans, which now make up over 60 per cent of the market for new mortgages. As base rates have risen and the housing market has slowed down, first-time buyers are in short supply. Desperate to attract new business, lenders are increasingly looking at existing homeowners who want to reduce their monthly payments by remortgaging.

Some lenders are offering fixed-rate deals at interest up to one percentage point cheaper than the competition. But they also carry a nasty sting in the tail.

Lenders can offer the cheapest deals, often so cheap that they make no profit for years, only because the money can later be recouped. Contracts lock customers in for years after the fixed-rate period is over, on pain of paying redemption penalties worth thousands of pounds.

The OFT's fear is that during that lock-in period, lenders can charge whatever interest rate they like. Consumers may be tempted by the attractive fixed rates without fully realising what may happen in a few years time, when the fix ends.

After the fix is over, interest payments can shoot up, and there is no realistic chance of escape. Theoretically, customers could suddenly find themselves paying 20 per cent.

But that is only in theory. Lenders, miffed by what they perceive to be an over-zealous OFT, say this kind of abuse hardly happens. Could the words "sledgehammer" and "nut" be appropriate?

John Heaps, chairman of the Building Societies Association and chief executive of Britannia Building Society, reckons the late lock-in allows lenders to shave more than half a percentage point off the upfront rate. If customers are properly informed, they can make a choice, pay more upfront and avoid the late lock-in. If the late lock-in were banned, the upshot would be less choice.

"If you are that way inclined as a lender, you can use people's ignorance to offer what may be a bad deal. That has happened but it's not widespread," Mr Heaps said.

Lenders say a voluntary system can work just as well. The mortgage code, developed as a way of staving off statutory regulation, can be altered. Lenders can be required to make sure customers know about mortgages with stings in the tail.

But the OFT broadside will still come as a blow to an industry struggling to recover from a PR problem which is not confined to mortgages.

A rash of complaints about banks during the last recession prompted the introduction of the banking code. The high street banks pledged to do their utmost to service their customers well. That was in 1992. The code has since been changed three times, in 1994, 1997 and this year.

The 1998 version was published on Monday. It strove to respond to bitter criticisms of Northern Rock, a newly converted building society. Earlier this year, Northern Rock wrote to its customers to tell them their accounts had been changed. For many customers, interest rates had gone down and notice periods had been changed unilaterally. Many customers were locked into a deal without having been informed ahead of the change.

Northern Rock later backed down, but not before it had been criticised by government ministers. And not before John Bridgman had launched another OFT inquiry.

The episode unearthed what has long been a questionable practice among banks known as "portfolio management". When banks began competing vociferously for customers in the 1980s, they sought to attract customers with big- sounding headline interest rates.

The trouble was it was expensive to offer market-beating interest to existing customers as well as new ones. The answer was to create a new account for new customers and pay the higher interest to them. The money for that higher interest was found by dropping rates for existing customers. Loyal customers were not told they were losing out in an "obsolete" account.

This week's code apparently cracks down on that abuse. Lenders can still launch a new account. But if it is similar to an old account, the interest rate on the old account must go up too.

A watertight solution? Not quite, says Brian Davis, chief executive of the Nationwide. Banks can still get away with the practice if they launch an account for new customers that's not "similar" to the old one. In that case all the code requires the bank to do is write to existing customers. And bankers know all too well how little customers respond to letters, even if it's in their interest.

"If banks and building societies were doing the right things in the first place this really wouldn't be an issue," Mr Davis says. "But in some way the code is really treating the symptom, not the disease."