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A loophole in the Government’s compensation system put in place to protect savers if their bank goes into liquidation means that some people may lose all their savings if they have both loans and deposits with the same company.

The Financial Services Compensation Scheme (FSCS) would normally refund depositors up to £35,000 if their bank or building society fails, but it says that if a saver also has a mortgage with that company, the customer’s savings could be taken and used to pay off the loan.

Put another way, in the event of a bank going into default the FSCS would consider the overall net claim. If the claimant’s borrowing exceeded their savings, there would be no overall claim against the bank and the claimant would not be entitled to any compensation.

This means that if a customer had a mortgage of £300,000 and savings of £100,000 with the same bank, a ‘set-off’ would be applied by the insolvency practitioner dealing with the bank failure. In this example the individual would end up owing the bank £200,000, so there would be no positive balance and no claim for compensation.

If the customer has more savings than debt with the bank, he or she could claim for compensation up to the £35,000 FSCS limit.

The situation is more complicated if the mortgage bank is part of a larger banking group and the customer has further savings in other parts of that group. Browne says it would then depend on the terms and conditions of the offsetting bank as to whether the insolvency practitioner could use those savings to reduce the mortgage

Building societies set different terms and conditions for their offset mortgages, so a customer’s savings might or might not be automatically offset against his outstanding mortgage if the building society failed. In the latter case the saver would still have to claim any money back through the FSCS.

In the past, it was traditional for people who wanted to borrow a mortgage to save with an institution before asking to borrow a loan from it too. This practice has become less common over the last 20 years, with the introduction of specialist lenders who raised their money through the money markets rather than by taking in savers’ deposits, and savings banks such as IceSave which offer high rates of interest on deposits but do not lend mortgages.

But offset mortgages, which combine mortgage loans, savings accounts and in some cases current accounts to reduce the overall amount of interest paid, would almost certainly be affected.

These loans allow borrowers to set savings against debt, effectively reducing the size of their mortgage without tying up savings on a permanent basis, and the ability to access their savings if needed is an important aspect of offset loans for many borrowers.

Offset mortgages were only introduced to the UK 10 years ago. However, the year-on-year popularity of offset mortgages has been much stronger than conventional loans, rising by 49 per cent between April 2006 and March 2007. In 2006 (the most recent figures available from the Council of Mortgage Lenders), offset mortgages accounted for loans totalling £23.9bn, or 7 per cent of all new home lending.

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The consumer organisation Which? has been looking into equity release schemes for the elderly of the type trailed so heavily on daytime TV.

Equity release allows retired homeowners to obtain money from their property without having to move out. People can be given a lump sum or regular payments in return for taking out a mortgage on their home, which does not have to be repaid until they die or sell their property. Interest is added to the amount owed until such time as a payment is made.

Alternatively, people who own their home outright can sell a portion of their property to a home reversion company. But Which? is warning that problems could arise if the borrower’s circumstances change.

In its conclusions, the consumer group says pensioners should only consider unlocking equity from their home as a last resort

Equity release schemes can be expensive, inflexible and leave people with little equity, according to Which? And any money people released from their property could also affect the level of means-tested benefits they are entitled to.

An individual who wanted to move into sheltered housing or a retirement home may have to pay back some of their loan earlier than expected. This could potentially leave them with too little equity to buy a new property, Which? added.

Equity release schemes approved by the Safe Home Income Plan (Ship) can be transferred to a new property. However, this does not always cover sheltered housing or retirement homes.

Which? is urging people to consider other options before turning to equity release. These include downsizing to a cheaper property, using their existing savings, or even borrowing money from family that could be paid back when their home is eventually sold.

The report says ‘equity release might seem like the solution for any pensioners struggling to make ends meet this winter since these schemes provide income while enabling you to stay in your own home.’

‘However, if your circumstances change you might not have enough money remaining to fund alternative accommodation, and money received through equity release may seriously alter the amount of benefits you are able to collect.’

I would echo the main recommendations of the Which? report. Anyone considering equity release should do so cautiously and only after exhausting other options. In all cases, independent professional advice should always be sought.