5 October 2018 - At the time of writing this column, HSBC has just raised the prime rate for the first time in a decade, from 5% to 5.125%.  This was not unexpected, though officially signals that we’re at the end of a long cycle of cheap financing.

Facing the start of a new interest rate environment, should buyers choose high mortgage plans to secure their properties?

The benefits of high mortgage plans allowing purchasers to borrow up to 80% of a property’s value (or even 90% for properties under $4M) are obvious.  A smaller down payment enables a larger purchase, or enables you to enter the market now instead of saving for many years for a down payment. This is naturally attractive for many buyers.

Two main types of institutions offer high mortgage plans - banks and developers.  (Independent money lenders also provide loans by using other assets as collateral and at high interest rates, though we won’t discuss them here.)

Banks are strictly regulated and can only offer high loan-to-value mortgages on purchases of $6M or below.  They require the borrower to pass income stress tests to ensure they can bear the additional interest burden over time, even if rates increase in the future (say, from 2% to 3%).  If expected interest payments are deemed to be affordable relative to the borrower’s income, then the application qualifies for mortgage insurance from the government-owned Hong Kong Mortgage Corporation and can be granted.

Developers can offer financing plans on their first-hand sales without a stress test, including for properties over $6M. Such loans typically use progressive interest rates that are low for the first few years (only slightly higher than bank rates), then increase to the Prime rate (currently 5.00-5.25%) plus X%.  Although this is significantly higher than banks’ lending rates (roughly double), these plans have been very popular, leading to strong first-hand sales in recent years. Knowing the progressive rate will become high, effectively increasing the all-in purchase cost  many buyers still choose to take this risk. Why?

Buyers often plan to refinance the developer loan with a bank loan in the future, before the progressive rate increases. Also, given property prices have increased steadily over the last decade, people may believe a 50% refinancing in the future may cover the 80% mortgage today. While this has been a plausible strategy in the past, the market may not continue to rise.  But the key mainly lies in the income stress test.

The ability to later refinance with a bank loan depends on the ability to pass the bank’s stress test at that time and qualify for mortgage insurance and a higher LTV loan. If they fail pass the test, then in order to avoid the high progressive rates, the buyer must come up with the additional downpayment (potentially 30%+ of the property value).  Otherwise, they cannot refinance and must begin paying the much higher interest cost.

This can be a tremendous burden if the purchase is outsized relative to one’s assets or income.  Since developers don’t conduct a stress test when granting a loan, the best way to protect against this is to conduct your own stress test.  Will your future income safely cover interest at a higher rate (3% or more)?  Will you have liquid capital to cover an additional downpayment, if needed, especially if property value falls? If you cannot refinance, will you be able to cover the progressive rate on the developer loan?  When considering a high mortgage loan, carefully consider these questions to be sure you will be in a good financial position throughout the life of the loan.

High mortgage plans from banks and developers can be a great tool if used wisely, but you must be disciplined, run your own stress test using conservative future assumptions and borrow responsibly.  Work closely with your bank or a professional advisor, and play it safe.

*Note: The above references an opinion and is for information purposes only.  It is not intended to be investment advice. Seek a duly licensed professional for investment advice.