Concerns are growing that many amateur landlords have fraudulently used residential mortgages to fund their buy-to-let properties.

These so-called “disguised” buy-to-lets occur when landlords – typically those with a handful of properties – pose as owner-occupiers to obtain cheaper and more flexible residential mortgages on property they have little or no intention of living in.

The financial regulator has uncovered the practice following a recent downturn in the buy-to-let market. Stagnant or falling prices for some city centre apartments have led to a number of landlords trying to offload cut-price properties quickly at auctions. The Financial Services Authority (FSA) says analysis of properties sold at auction last year found that although many were commonly classed as owner-occupied by their sellers, 80 per cent were in areas where buy-to-let was prevalent, suggesting that many were “disguised” buy-to-lets.

The FSA said that consumers abusing residential mortgages often did not understand the risks associated with the buy-to-let market and did not have alternative sources of finance to cover “empty” periods when they were not receiving rental payments.

Landlords struggling to rent out their properties have also had to deal with a slowdown in price growth. The average price of a new flat increased by just 0.8 per cent between the second quarter of 2004 and the first quarter of 2006, according to the FSA, leaving many amateur landlords with poorly-performing investments. The FSA said the percentage of repossessed properties appearing at auctions had risen to 25 per cent in December 2006, up from just 8 per cent in February of last year. It believes this number could increase in coming months as higher interest rates bite.

The FSA said: “Where questionable activity has been identified this is being raised with lenders.”

Ironically, buy-to-let mortgages are now much closer in price to residential loans due to competition and lenders’ greater experience with the sector. Giraffe Money, for example, has a three-year fixed-rate residential loan at 6.08 per cent. Its buy-to-let equivalent is only marginally more expensive at 6.15 per cent. Cheshire Building Society has a two-year buy-to-let fixed rate at 5.7 per cent while its equivalent residential loans vary from 5.54 per cent to 6.24 per cent, depending on the arrangement fee.

But lenders and brokers admit there are still some attractions to using residential loans to fund buy-to-let properties. One is that they usually allow larger amounts to be borrowed against a property’s value – 95-100 per cent compared with a typical maximum of 85 per cent for buy-to-let. Residential loans also provide capital gains tax relief because no CGT is paid on the sale of a main residence. However, residential loans do not allow the landlord to claim tax relief on interest payments.

Rob Thomas, senior policy adviser at the Council of Mortgage Lenders, has been monitoring the disguised buy-to-let sector closely this year. He says: “Our advice is that if you are lying to your lender by using disguised buy-to-let you are effectively committing fraud and people who do that will often face the consequences, so the best policy is to be honest with your lender.”

Mark Harris, managing director at London broker Savills Private Finance, warns: “Borrowers need to be extremely wary before trying to use residential loans to fund buy-to-let. There could be serious financial and legal consequences if they are found out because they are breaking the terms of their agreement. Anyone who wants to get into buy-to-let should consult a good professional mortgage broker about a buy-to-let loan.”

He adds that there is plenty of choice available, and it is no longer necessary to pay such a premium on buy-to-let loans compared with residential deals.

Linda Will, managing director at Accord Mortgages, which sells residential home loans exclusively through intermediaries and is soon to launch buy-to-let mortgages, says: “People should be aware that lenders are not daft. We have a lot of sophisticated electronic fraud checks these days to provide an early warning of potential abuse. If people blatantly lie on their application they will get caught out.”

Ray Boulger, senior technical manager at John Charcol, says in some cases buy-to-let loans are actually now cheaper than residential loans, eroding one of the main reasons to cheat.

For borrowers who are discovered using disguised buy-to-let, the penalty is usually an extra administration fee – typically £75-£500 plus a penalty interest rate.

This could add up to an extra 1 percentage point on loan rates, pushing, for example, a 5 per cent mortgage up to 6 per cent or more, adding thousands of pounds to annual payments. Penalties are lower or non-existent if borrowers have informed lenders in advance about letting a residential property – so-called “authorised lets”, say, when working abroad for a year.