Considerations
Selecting the currency in which to borrow is one of the most important considerations when borrowing offshore. Setting up an offshore mortgage in an alternative currency to that in which your income is earned and the loan monies are used introduces currency/exchange rate risk.
We look for healthy choice of mortgage options covering a range of different ideas - variable rates, fixed rates, or even a mixture of both.
Terms and conditions will vary between expatriate mortgage providers. Be certain that you fully understand the terms and conditions of the mortgages on offer – for example, the date a particularly favourable opening rate will come to an end and what happens to the rate after that date. What are your obligations for accepting a special mortgage package? Will acceptance leave you tied to a mortgage for the entire term, will you be able to redeem the mortgage at a date of your own choice. Will there be any penalties for early redemption?
Most lenders these days are relaxed about expats letting out their properties to tenants whilst overseas. However, some mortgage providers take a dim view of lending against a property which is not the principal family home or used in that way and it is vital that, at the outset, you declare how the property will be used. This is not only important in your dealings with the mortgage provider but also with the insurance company with whom you will be securing mortgage protection, buildings and content insurance.
Currency
As a general rule, it is recommended that a mortgage be taken out in the same currency to that in which your income is earned and the loan monies are utilised. For example, if you earn sterling income and you are borrwing to purchase a UK property (maybe even earning UK rental income) to which you will return then a sterling mortgage would be most desirable. This clearly avoids the heartache caused by currency and exchange rate risks, and the risks are high.
For expatriates earning in other currencies, such as Sing dollars or Euros, and who are buying a property for their own use, a foreign currency mortgage may be the best option. Lenders can often set up the loan using an offshore bank account and payments can then be made in the same currency as your salary.
The attraction of offshore mortgages often lies in the fact that interest rates in other countries can be considerably lower than that in which you earn your income.
For example, one would think that choosing a HK$ 4% mortgage over a GBP 6% mortgage would make sense but simply choosing a mortgage in an alternative currency because of a significantly lower interest rate is a common mistake…see below.
Suppose a UK individual needs to borrow one million GBP for a period of one year. The one-year rates offered by UK and HK banks are 6% and 4% respectively, and the current $HK/£ exchange rate is 0.625. If the individual decides to borrow from its UK bank, it receives $1 million today and repays $1.06 million one year from now. Straightforward.
Alternatively, as the HK rate is lower the offshore option involves borrowing HK$1.6 million today, which can be converted to HK$1.6 times 0.625 = £1 million. One year from now, the Hong Kong bank requires payment of HK$1.6 times 1.04 = 1.67 million HK$. This costs the UK individual S1 times 1.67 million dollars, where S1 is the spot exchange rate of sterling for Hong Kong dollars one year from now. If the exchange rate one year from now is 0.66, the individual requires 0.66 times 1.67 = £1.11 million to meet its repayment to the Hong Kong bank.
Note that this exceeds the £1.06 million required under the domestic alternative.
Conversely, if the exchange rate one year from now is unchanged at 0.625, the individual requires 0.625 times 1.67 = £1.05 million to meet its repayment to the German bank and the offshore borrowing appears to have paid off.
The effect of borrowing offshore is that it has introduced foreign exchange rate risk. If the funds are borrowed domestically, the amount to be repaid is a certain £1.06 million. If the funds are borrowed offshore, the amount to be repaid is arbitrary, depending on the exchange rate one year from now.
Hedging
Foreign exchange rate risk can be hedged or protected against. The only way to perfectly hedge against this risk is by use of ‘forward contracts’. A forward contract is a foreign currency contract to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period. They are used when an investor has an obligation to either make or take a foreign currency payment at some point in the future. The investor in effect "locks in" the exchange rate payment amount.
However, due to ‘covered interest rate parity’ the forward contract exchange rate will always roughly equal the spot exchange rate at that time and the effect will be neutral. Therefore, our individual in the example above will have repaid £1.06 million by either borrowing GBP or borrowing hedged $HK …a neutral result but the risk is mitigated.
The cost of a forward currency contract is primarily a function of interest rates. The premium to cover the cost of carry for even a short period like six months can be expensive, when interest rate spreads are high, if a currency is being devalued. This is essentially the investor's cost.
Conclusion
Unhedged offshore borrowing introduces exchange rate risk
Perfectly hedged offshore borrowing is financially equivalent to domestic borrowing. The decision of whether to borrow offshore or domestically should be driven by taxation and strategic considerations
