By Steve Slater and Matt Falloon

LONDON (Reuters) - Millions of people bracing for a jump in mortgage costs look set to have the blow cushioned by a cut in interest rates this week but face pain ahead as house prices fall and risk-averse lenders ration credit.

A shortage of supply from lenders due to a global credit crunch is posing most problems for an estimated 3 million homeowners whose repayments will rise this year.

It has also left first-time buyers unable to take advantage of lower prices as lenders shun riskier customers and demand bigger deposits.

"The situation is going from bad to worse," said Ray Boulger, technical manager at mortgage broker Charcol. "Lenders are trying desperately to avoid getting more business than they can cope with, either because of the amount of funding they've got allocated to the mortgage market or because of service."

Number one lender Halifax on Tuesday said house prices fell at their sharpest rate since the recession of the early 1990s, far worse than expected -- stoking fears a moderate slowdown will deepen and bring home repossessions and negative equity.

That shook confidence in the housing market's resilience and raised expectations the Bank of England (BoE) may opt for an aggressive rate cut when it announces its next rate decision on Thursday. It had been expected to cut rates by 25 basis points.

"It is fair to say that this (Halifax report) is not a hiccup, but the start of a correction which is likely to run through the rest of this year and next," said Seema Shah, a property economist at Capital Economics.

Few economists are forecasting a repeat of the housing market crash in the early 1990s. Then, house prices slumped and the country plunged into recession after interest rates were hiked to cool an overheating economy.