* Bank lending up 1.9 pct yr/yr in June - BOJ
* Biggest gain since July 2009, 20th month of rise
* BOJ likely to hold steady, revise up economic view
* Service-sector mood worsens in June - govt survey (Adds service-sector sentiment survey)
By Leika Kihara and Kaori Kaneko
TOKYO, July 8 (Reuters) - Japanese bank lending marked its biggest annual increase in four years in June, though service-sector sentiment worsened for the third straight month, undercoring the challenges facing the government even as its sweeping stimulus policies continue to spur economic momentum.
Outstanding loans held by Japanese banks rose 1.9 percent in June from a year earlier, Bank of Japan data showed on Monday, marking the 20th straight month of increase and posting the biggest gain since July 2009.
"The recent increase in demand for funds is related to mortgage lending and the housing market," said Shuji Tonouchi, senior fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities.
"I expect bank lending to continue to steadily increase, which is part of the portfolio rebalancing that the BOJ is trying to encourage."
Borrowing for investment in real-estate trust funds, and overseas mergers and acquisitions, also contributed to the increase, which followed a 1.8 percent rise in May, a BOJ official told a briefing.
The data bodes well for the BOJ, which hopes its aggressive stimulus plan will encourage banks to funnel money to lending and risky assets, instead of loading up on low-risk, low-return government bonds. It forms part of the central bank's strategy to spur growth and vanquish years of entrenched deflation.
The BOJ stunned markets on April 4 by setting in motion an intense burst of monetary stimulus, pledging to double its holdings of government bonds and boost purchases of risky assets to achieve its 2 percent inflation target in two years.
Data released last month confirmed Japan was already out of the shallow recession that took hold in late 2012, as the economy grew at an annualised 4.1 percent in the first quarter of this year.
However, there's also evidence to suggest that the road to a sustainable recovery will take some time.
Financial markets suffered a brief setback in late May through early June with concerns of slowing Chinese growth and growing expectations of a reduction of the U.S. Federal Reserve's bond-buying programme hitting global shares, including Tokyo stocks.
That dented some of the feel-good mood generated by hopes over Prime Minister Shinzo Abe's sweeping stimulus policies, hurting Japanese retailers vulnerable to consumer and retail trends.
An index measuring service-sector mood dipped 2.7 points from May to 53.0 in June, a government survey showed on Monday, marking the biggest fall in a year. Rising import costs and bad weather during the month, which kept consumers at home rather than shop, also weighed on sentiment, according to the survey.
The government revised down its assessment on the index for the first time in eight months to say the pace of recovery is moderating, but added the deterioration in sentiment was likely temporary -- a view shared by many private-sector analysts.
"This sentiment survey reacted rather quickly to the recent stock price falls, but the economy is on a solid footing," said Yoshimasa Maruyama, chief economist at Itochu Economic Research Institute in Tokyo.
The BOJ is widely expected to stand pat on monetary policy this week and revise up its assessment of the economy to suggest that the world's third-largest economy is recovering thanks in part to the government's reflationary policies.
Separate government data showed on Monday that Japan's current account surplus rose 58.1 percent in May from a year earlier in a sign that recovering exports and hefty gains from overseas investments helped the nation's balance of payments. (Additional reporting by Stanley White; Editing by Shri Navaratnam)