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Financial Adviser - May 2006

The Grass is not always Greener

Foreign interest rate mortgages may look like a bargain, but currency fluctuations could cost you more, writes Jonathan Cornell

One effect of globalisation has been an increased awareness of foreign interest rates. Borrowers are becoming more astute at comparing options.

Over the past couple of years, we have seen more lenders launching products that track foreign interest rates, which have been considerably lower than those available in the UK.

Taking out foreign currency mortgages is not a new phenomenon. In the 1990s, we saw a lot of interest in yen mortgages as the interest rate was so much lower than ours.

The trouble was that people needed to pay these loans in yen, so each month they had to convert some of their salary to yen to pay the mortgage. When the yen strengthened against the pound suddenly servicing this loan got a lot more expensive. For example, £1 currently buys about ¥207. If your mortgage payment is ¥207,000, this would cost £1000 a month.

However, if the exchange rates changes and £1 only buys ¥150, then your mortgage payment is still ¥207,000, but this now costs you £1380 a month.

Another effect was that the currency appreciation also affected the level of equity in the property. Clients suddenly saw their equity disappearing as a result of currency fluctuations.

Using the same example, assuming the debt was ¥1.4m yen, then your debt would increase to £276,000.

However, do not forget that if the yen got weaker against the pound then the borrower would see his monthly mortgage balance fall as well.

Too many people, who did not understand the risks, got their fingers and finances badly burned.

Several lenders have come up with safer ways of helping clients benefit from low foreign rates.

About 18 months ago, lenders such as Skipton and Accord launched products that tracked US Libor, but were structured so that the debt and the monthly repayments were in sterling. The only downside was that clients had to pay a substantial margin over the foreign rate, typically 2 per cent. This margin enabled the lenders to use derivatives to structure a sterling mortgage on a dollar rate.

Margin
Even taking into account this margin, when the US Federal Reserve rate was 1 per cent, clients still had a lower rate than they would have on a UK base-rate tracker.

But now the US Federal Reserve rate is 4.5 per cent, and may even increase to 4.75%, which means these clients are paying more than their neighbours who have UK base-rate tracker mortgages.

Also, these products needed to be structured over a fairly long period, typically five years, so these clients are now tied in for another three and a half years and are paying more than most UK borrowers, even the ones on standard variable rates. So, not only are they on a higher rate, they are tied in with early repayment charges to get out.

Derbyshire has launched a few five-year Swiss franc Libor tracking loans with a 3 per cent margin.

The fact that Swiss Libor is now just more than 1 per cent means clients can have payments at a little more than 4 per cent, which looks good value compared with UK base-rate trackers, but who knows if Swiss interest rates will remain so low. If the UK base rate falls, it will mean that the differential between UK mortgages and these is pretty minimal. Is the risk worth it?

Adventurous
For borrowers who are financially adventurous, astute and need largish loans, a company called ECU actually offers to manage a multi-currency mortgage on the borrower's behalf.

While risks exist, as I have already outlined, ECU's results have been incredible.

According to its website, over the past five years, the average interest rate it has obtained for its clients plus a margin of 1.75 per cent is 3.43 per cent, compared with a UK interest rate of 6.14 per cent, though admittedly this is an SVR type figure rather than a best-buy rate.

Looking at the figures for the value of the reduction in the capital value of the mortgage, the results look amazing.
In the past five years, it has managed to reduce it's borrowers' debts by almost 25 per cent.

Clearly mortgages that track foreign interest rates are not suitable for the vast majority of borrowers. Some people gain and some lose when they think that the grass is greener on the other side.

Jonathan Cornell is technical director of Hamptons International Mortgages.

ftadviser.com

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I have read and understand Risk Warnings.

Foreign exchange movements can be sudden and substantial. At no stage should you expose yourself to the high risks of foreign currency exposures if you are not able to afford the potential losses that could result from sizeable adverse currency movements and the higher interest rate servicing costs that would be required of you in the event of your having a larger debt.

Denominating debt in foreign currencies may not be suitable for you. Changes in the exchange rate may increase the sterling equivalent of your debt. Your lender will not tolerate too great an increase in the sterling equivalent of your debt as a result of currency losses and may opt to convert your debt back into sterling at a predetermined level. This may result in a permanent increase in the sterling equivalent of your debt which is not fully compensated for by any other benefits derived during the course of The ECU Group plc's discretionary currency debt management services. In this event, you could be left paying UK interest rates on a larger amount of sterling debt than that you originally borrowed. Your home may be repossessed if you do not keep up repayments on your mortgage.

Your lending bank sets a 'Conversion Limit' at which level they have the right to convert your managed multi-currency mortgage back into sterling to prevent further currency losses. It is important to understand that this is a right of your lending bank and not an obligation and that if they do not act promptly to convert your loan back into sterling when your Conversion Limit is reached, your loan could increase by more than that specified by your Conversion Limit.

ECU may from time to time transfer your loan into foreign currencies with higher interest rates than sterling with the objective of achieving a debt reduction in that currency.

Sterling interest rates are subject to change and the differential between sterling interest rates and the interest rates of other foreign currencies will fluctuate.

Suitability
The markets or financial instruments discussed herein may not be suitable for all investors and investors must make their own investment or participation decisions using their own independent advisors as they believe necessary and based upon their specific financial situation and investment objectives. Past performance is not a reliable indicator of future performance, and should not therefore form the basis of a decision whether or not to buy or sell any investments or financial instruments or to participate in any particular trading strategy mentioned herein.

The UK Regulatory System
The ECU Group plc ("ECU") is authorised and regulated by the Financial Services Authority.

In respect of managing physical liabilities in foreign currencies, ECU trades the foreign exchange markets on a spot basis and issues switch instructions to lending banks on a spot basis. Neither of these activities is currently regulated by the Financial Services & Markets Act 2000 as they meet the "Commercial Purposes" test. Therefore you will not benefit from the protection of the Financial Services and Markets Act 2000.

However, if ECU instructs the Lender, or any prime broker or counterparty with whom ECU effects foreign exchange transactions, to conduct a switch by way of effecting an “option” or “futures” transaction for the Client’s account, such transactions may be considered to be an “investment of a specified kind” under the Financial Services and Markets Act 2000. Consequently, both the execution process provided by the Lender, or any prime broker or counterparty with whom ECU effects foreign exchange transactions, and the currency management services provided by ECU, as envisaged under this Agreement, may be considered to be regulated activities. In such instances, the Client may be required to sign additional risk warnings and the rules for the protection of investors under the Financial Services and Markets Act 2000 will apply.

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