The Government has paved the way for the return of local authority mortgage lending by cutting the minimum interest rate that councils can charge homeowners.

Council leaders said last night that the Department for Communities and Local Government had given them a green light to intervene in the UK’s stricken mortgage market after the “national standard rate” was cut from 5.07 per cent to 3.93 per cent yesterday.

It is now on a par with the most competitive rates in the mortgage market. This time last year local authorities wishing to offer home loans were forced to charge 6.89 per cent.

In the two decades up to the early 1980s councils were a major source of mortgage finance for residents who commonly borrowed 100 per cent of the value of their property over 25-year terms. In 1980 there were 600,000 borrowers with local authority mortgages, around 16 per cent of the market.

The introduction of 1985 Housing Act meant councils could only lend at a national standard rate, or the local average borrowing rate, designed at the time to be prohibitively expensive.

Chris Leslie, of the New Local Government Network, a left-wing think tank, said: “Historically councils were a major force in the mortgage market but Margaret Thatcher believed it was a job for the private sector. It is clear that there has been a thawing of the idea in the Government that the housing market needs mortgage liquidity from any source willing to offer it.”

A number of local authorities, including Birmingham, Liverpool, Portsmouth and the London boroughs of Lambeth and Hackney, have expressed an interest in mortgage lending.

Councils are expected to work with financial institutions to establish good lending practices. Authorities could borrow cash from the Government to fund new mortgage lending or raise extra capital from wholesale markets, although it is understood that the Treasury is resisting any scheme that further inflates the public debt.

Local authorities are keen to support homeowners who cannot get on the house ladder but deny that they that would be willing to fill the gap in sub-prime lending to riskier borrowers.

Steve Reed, Leader of Lambeth Council, said: “There are individuals out there with good incomes and stable jobs who cannot get a mortgage and that is who we would be interesting helping. The interest rate was always a stumbling block preventing councils offering competitive mortgages to first-time buyers but now it is a real possibility.”

Mortgage lending by banks and building societies plunged by 47 per cent last month to reach a record low, according to the Council of Mortgage Lenders, the industry trade body which represents 99 per cent of mortgage lenders in the UK.

Gross mortgage lending fell to £12.6 billion, down 11 per cent from £14.2 billion in November and 47 per cent from December 2007 when banks and building societies agreed £23.8 billion in loans for mortgage borrowers.

The Government has indicated that it is looking at a range of alternatives sources of mortgage finance while banks and building societies struggle to boost the number of deals available to homeowners.

Last month, Gordon Brown announced plans to give Northern Rock more time to repay its Government loan .This should result in less homeowners being forced to remortgage to rival banks and raises the possibility of an increase in new mortgage lending.

The Government is also considering expanding the role of the Post Office to create a "people's bank" to provide mortgages, as well as current accounts and personal loans.

Bernard Clarke, of the CML said: “I’m not sure that local authorities would have the capacity to full the funding gap which exists in the mortgage market. It is difficult for local authorities to run fully fledged mortgage businesses and their efforts could be better directed at problem of rising repossessions and homelessness.”