By Sinead Cruise and Lawrence White

LONDON (Reuters) - Britain's banks are accepting smaller profit margins and bigger risks on UK mortgage lending as stress in sterling money markets stretches into a second week, industry sources said, with appetite to lend greater than worries about higher funding costs.

The cost for banks of hedging their mortgage lending via products known as swaps has risen as a spike in UK government borrowing costs to multi-decade highs has kindled fears Britain may struggle to meet its fiscal rules.

While investors are demanding bigger returns to hold UK sovereign debt, major banks are for now still willing to lend through the malaise without immediately passing on higher costs to customers seeking home loans, the industry sources said.

One source at a major UK lender said the mortgage market remained very competitive and banks were prepared to swallow lower asset margins and wider liability margins on lending to keep activity levels high.

Lloyds Banking Group, NatWest, HSBC, Barclays and Britain's biggest building society Nationwide are continuing to jostle for a bigger slice of Britain's mortgage market, with such assets typically providing consistent income streams to offset bank balance sheet liabilities, including interest-bearing deposit accounts.

British house prices dropped unexpectedly by 0.2% in December for the first time since March, figures from mortgage lender Halifax showed. Prices ended the year 3.3% higher, a lower annual rise than the 4.2% forecast in a Reuters poll of economists.

Some analysts say those falls could stimulate housing market activity this year, but other data show borrowers remain worried about possible hikes in the cost of mortgage debt.

According to a Barclays Property Insights report published this week, consumers' confidence in their ability to afford their rental and mortgage payments dropped three percentage points to 52% in December, the lowest level in 2024.

Rachel Springall, finance expert at Moneyfacts, said lenders still needed to make efforts to entice new business.

"There are millions of borrowers due to come off fixed deals, so remortgage activity will be booming in 2025," she said.

CALM CONVICTION

Banks use swaps to manage the risks of their mortgage lending. The price of two-year swaps has risen to 4.6%, the highest since July 2024, while five-year swaps have risen to 4.52%, the highest since November 2023.

Average two and five-year mortgage rates have only inched up 0.02% each since Friday, data from Moneyfacts as at Jan. 14 showed, with average 5-year mortgages at 5.27% compared to 5.25% on Jan. 1.

News of the banking sector's sanguine approach to mortgage lending will be welcomed by Prime Minister Keir Starmer and finance minister Rachel Reeves, as they battle to meet fiscal targets and reassure international investors the UK is still a safe, rewarding bet.

The annual rate of inflation slowed last month to 2.5%, official data showed on Wednesday, soothing markets and providing some relief for policymakers.

Sustained gradual increases in swap rates have chipped away at profit margins on mortgages but lenders continue to compete hard for business, despite the rising cost of funds, said David Hollingworth, Associate Director at L&C Mortgages.

"The inflation figures today will help give a bit more positivity and a further element of stability into mortgage rates as it will firm up the hopes for a cut in base rate next month," he said.

HSBC cut mortgage rates on Jan. 6 by up to 0.47% for existing customers, and also made further downward changes on Jan. 13 to select products.

"We frequently review mortgage rates, and a number of factors are taken into account when setting them, but we remain focused on continuing to provide competitive rates," a spokesperson for the bank told Reuters.

(Editing by Christina Fincher)