Advice on a Re-Mortgage & Investment Plan

[SDY888]

Can the collective wisdom of the Board please pitch in and help with views and ideas on the following situation:

Any risks / pitfalls I have not addressed? Advice please.

From my previous post you may recall that at 34yrs, we are in accummulation mode, trying to max the return on every dollar for future ER. Thus, current retirement, imminent ER plans, or dependency on investment income are not applicable to our current situation.

Here's the deal:

I have a second property which is currently rented (good tenant, long term lease). I have talked to the mortgage lender for my personal residence about transferring to them the mortgage on the rental property. I have negotiated a deal and have a written offer and am now deciding whether to proceed and if so, how.

The Rental Property:

Current value - 450,000
Mortgage Outstanding - 128,000
Equity - 322,000

They will offer me re-mortgage terms of 1.18% for one year, rising to Best Lending Rate minus 2.7% thereafter for the remaining life of the mortgage. Best Lending is currently 5%, so that equates to 2.3%. This part is a no brainer as I will definitely move the mortgage and bag the low rates. However, a further option is available.

I can increase my loan amount by a further $128,000, thereby reducing my equity to 43% and increasing liability to 57%.

The additional monthly payment will be around 780 per month, of which 125 is interest and 655 capital repayment. Annually, I will pay approx 1500 in interest in the first year followed by around 3000 in the second year and falling off thereafter as the capital is paid down.

I take the view that the capital repayment is effectively paying money to myself (as I simply swap cash for equity in the property). However, to achieve this I will have to pay around 600 a month from other income to make up the shortfall in rental income over the total expenses (mortgage, management fees, insurance and taxes).

My thoughts were to take the capital released from this deal and put it into a reasonably secure investment vehicle, which will earn more than the 1.18%/2.3% in interest I will pay. (I am currently looking at interest rate linked products, but the search has only just started). I consider that even a relatively conservative investment should yield around 4%, currently, and only a little extra risk could raise that to 5% or even 6%. I will also have to factor the loss of opportunity on the additional 600 a month to pay. Looking forward, interest rates are sure to rise, but by locking into these rates now I at least get the use of ''Cheap'' money for a while and I always retain the option of simply reverting to the bank and paying the mortgage back down again (there is only a penalty on repayment for the first year of the loan). With the Best Rate -2.7% deal, interest rates will I think have to rise pretty far before I start to lose out.

Thoughts, comments, ideas, warnings?

Thanks,

Simon888

 

[Nords]

Who the heck is giving away ARMs at 2.3%?!  (ntip)

 

[SDY888]

Sorry. I should have qualified by saying that the deal is NOT in the US. The deal is available in Hong Kong, where the HK$ is pegged to the US$ (and has been for about 25 years).

Interestingly, Bank of America are offering Best Rate minus 2.7%, with an introductory 6 month period at, wait for it, 0.85%, but their lock in period is longer.

 

[dex]

Is this a commercial property or residential?
The missing factor in the equation is risk.

The interest rate is low, so do you have a guarantee from a AAA corporation on the rental? If you do I can understand the low rate.

If you don't have a guarantee why the low rate? Are you personally liable or pledging other assets?

 

[SDY888]

Just noticed that I have been promoted from a 2 star wannabe to a 3 star aficionado

 

[dex]

I used to live in Hong Kong - tell me about the property.
When you get the chance answer my questions.
How often can the bank change the rates?

 

[SDY888]

Dex,

The property is residential. The tenant is a civil servant and the rent is guaranteed by the Government. As for the rates on offer, they are available to any existing customer or homeowner who wishes to move or extend their current mortgage, or take a further mortgage, so I have made no additional or special commitments. The loan is still linked to the Prime rate (currently 5%) and so that portion remains variable, but we will always pay 2.7% less than Prime. The bank can vary the rate paid by borrowers as and when Prime moves, but historically they tend to do it 2 or 3 times a year as necessary.

S888

 

[wabmester]

The risk with any variable rate loan is, of course, in the *variable* part. The prime rate is currently 4.25%, but it was 9.5% as recently as 2001.

US banks typically lend at prime+something, so if you have access to capital at prime-2.7%, then get the biggest loan you possibly can and open your own bank.

 

[SDY888]

Wab,

Many people have access to funds at these rates, so opening the bank would not attract too many clients, but the principle remains the same - find a vehicle paying more in returns than I pay in interest. There is another balancing act to perform which is to borrow enough to make it worthwhile but at the same time still be able to service the repayments from regular income. My figure for that is 128,000.

You have a good point though that the risk lies in the variable rate (Hong Kong banks do not offer fixed rate mortgages). As the rates will most likely continue to climb, I also need to ensure that whatever I choose to do with the capital raised, it will not fall too precipitously such that I cannot at any time cash out and repay the additional mortgage. Thus, good corporate or Gov bonds are pretty much a non starter at their current prices.

This short-ish term arbitrage kind of idea would not normally form part of our general investment/accummulation strategy, but it seems to me to be a good opportunity as we appear to be in the last stages of the heavily discounted mortgage rate offers and the overlap into a rising rate environment has just begun. Thus I look upon this as a chance to make a few thousand in safe-ish returns by using someone else money effectively for free.

Also a consideration is that overall, we have a relatively small debt to equity ratio of around 0.28.

BTW, I can also remember a time when prime was in the mid-teens so I am very mindful of the other side of the coin from these low rate times.

Thanks for the post, always good to use the wisdom and experience here as a sounding board.

Cheers

Simon888

 

[wabmester]

Simon, I just threw that obvious arb play out there as a straw man, but I really doubt if anybody on this board can give you good advice.    Personally, I have no idea what level of control China will exert over HK, what their timetable is, whether they'll decide to let the yuan float, what interest rates will do in HK or how to hedge against all of those uncertainties with US investments.

The other obvious play would be to arb against some HK investments, but I assume if money is that cheap, then safe HK investment returns must be abysmal.

 

[SDY888]

Wab,
Thanks for the reply. As I do not have many sounding boards or points of reference to ''think aloud'', debate and chew these things over with, I sincerely appreciate all replies and comments, if only to point out the obvious, reconfirm my own thoughts or tell me I am dumb. So thanks again for your input.

My thoughts have been to hedge with a HK demoninated asset, but as you say, returns are low: 3 to 5 year triple A rated paper (HK Gov bonds, HKMA, quasi-gov corps) are giving up variously between 1.5 and 2%. Very expensive. An alternative would be to put the funds in a US$ money market account at around 2 - 2.25% for the first year when I am making 1.18% interest payments. The currencies are pegged so negligible FX risk. At least that route would keep the funds liquid to pay-off the loan if necessary or to continue the search for better yielding alternatives.

Still, the allure of money at 1.18% money for a year and at P-2.7% for ever after draws me to think that in a future rising rate environment, the opportunities will appear.

Food for thought.

Thanks, Simon888

 

[haha]

I sincerely appreciate all replies and comments, if only to point out the obvious, reconfirm my own thoughts or tell me I am dumb.

Unless you are performing some service for someone, and the low rate is essentially compensation, I would say that there isn't any kind of risk free arbitrage available anywhere, including in the situation you describe.

You mentioned that the HK dollar is pegged to the US$. True enough, but the Mexican peso was pegged to the USD for many years. Lots of people borrowed money in the US and put it in Mexican banks at high interest rates. It worked until it didn't, as Mexico decided to float its currency. Another far out but not impossible risk is currency controls, should you bring the cash to the US for investment.

What will happen to the HK dollar if the renminbi is re-valuated? This possibility is not completely off the wall.

If you are willing to do time arbitrage, and keep the money you borrow in Hong Kong, the hazards seem describable at least. If there are no penalties to closing out the loan early, and no upfront costs that need to be amortized over the life of the loan, and if you can find absolutely safe short term investments for the cash, you are only out the spread.

Whether you make or lose money would then depend on how long it takes for more attractive long term opportunities to present themselves. Eventually, you either have to accept the borrow short/ lend long problem, or find an investment that although not priced as absolutely secure, in your opinion is. So then you are betting that you are a better credit analyst than the market. This could be true.

Overall, it strikes me as a species of the general class of free lunches.


Mikey

 

[wabmester]

A similar, but simpler situation was discussed in "depth" (as in deep doo-doo) wrt carrying a fixed-rate US mortgage and investing the principal.

The options boil down to:

1) debt is bad, don't do it!

2) do it if you can invest the cash and get higher returns with risk and term character similar to your mortgage (e.g., LT bonds with coupons > your interest payments)

3) invest in short-term instruments that give you something like a break-even return, and then see if better opportunities present themselves down the road (and, if not, pay off the loan)

4) invest the money as you normally would, hoping that your long-term returns beat your interest costs (with your confidence boosted by historical returns), and try to keep liquid enough that you can cut your losses by paying off the loan if you lose your nerve

I'm in camp (3), but I would only play the game with a fixed-rate loan, not an ARM, and certainly not a foreign ARM.