To help fund this the Treasury will provide an extra £10bn in taxpayers money to the bank.
"This is good news for customers of Northern Rock and for consumers generally, who will benefit from an increase in mortgage availability," said the bank.
"The new lending proposition means that the company's existing mortgage customers will not be actively encouraged to leave when their mortgage deal matures and they will have more choice," it added.
This means they will now be able to apply for some of the favourable deals which have been on offer to new customers only.
Chancellor Alistair Darling also suggested that some mortgages would be lent at up to 90% of the value of the property being bought.
Currently, mortgage lenders typically require a deposit of at least 20% of the purchase price.
Liberal Democrat Treasury spokesperson Vince Cable said the "90% rule" was a start, but urged the government to clarify the rule and apply it to all lenders, "not just Northern Rock".
Mr Darling said the new plan was one of a series of measures being taken to rebuild the banking system.
Director of the Council of Mortgage Lenders, Michael Coogan
"[Northern Rock] repaid about £18bn of the loan the government made, and I said in January this year that because of the problems the mortgage market faced, instead of looking to wind down its business, it would be better for Northern Rock to maintain lending," he said.
This change in policy should also help other lenders who have taken on a large number of former Northern Rock customers who were effectively encouraged to switch lenders so that the bank could pay off the government loan.
"By removing this market pressure, other lenders as well as Northern Rock should experience an increased capacity to lend to other borrowers," said Michael Coogan of the Council of Mortgage Lenders.
With the value of all new mortgages currently averaging £112,000, an extra £5bn of lending would amount to about 44,600 averaged-sized home loans per year.
That would be roughly equivalent to the number that were lent each month last year by all lenders in the UK.
However the bank's financial problems are not over.
As well as the huge loss for last year, it revealed that arrears among its mortgage borrowers have risen rapidly.
Nearly 3% of these borrowers are now in arrears by more than three months, up from less than 2% last September.
The bank said the problem lay particularly with people who had been given 125% loans under its notorious "Together" mortgage policy.
And it warned that it would still be "significantly loss making" this year.
The bank's new bonus arrangements mean that while senior staff will not get bonuses, frontline staff at Northern Rock, such as bank tellers, will receive bonuses worth up to 10% of their salaries for 2008.
That is because they helped the bank achieve its target of repaying a large part of the government loan taken on prior to its nationalisation early last year.
In addition, junior management will receive a bonus for 2008, but this will be deferred until 2010 and can be clawed back if performance criteria are not met.
Northern Rock said the frontline and junior management bonuses covered about 4,400 workers with an average annual salary of about £21,000.
The bank also said that "senior individuals who are important to the company's future" would also receive a deferred bonus, payable in 2010 if certain criteria are met.
A change in the nationalised banks' lending policy first became apparent last month when the government announced steps to revitalise the moribund mortgage market.
Northern Rock collapsed in 2007 after a run on savers' deposits when it emerged it had sought government help.
When the bank was nationalised last year it pledged to reduce the amount of state aid it would borrow.
However, in January this year, the lender was given more time to pay back its £27bn government loan as part of broader government efforts to boost lending, which it is hoped will aid economic recovery.
Previously, the bank had been encouraging customers to re-mortgage with other lenders so it could quickly pay off the loan, but this policy is now being stopped.
Greg Hands, shadow treasury minister, told the BBC the reversal of policy showed the "chaos" at the heart of government decision-making.
"We've been calling on the government for some time to free up credit in the economy and to make sure credit flows," he said.
"However, for Northern Rock it is a bit of a volte-face because until now Northern Rock had been under orders to wind up its mortgage operation and essentially to close down business," he added.
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