Carry trade mortgage: Hair fully ablaze or just gently smoldering? (Long!)

[Zarya]

OK, I'm hoping this question will interest some of the people who enjoy running calculations, because I'm finding that coping with all the variables is taxing my otherwise-logical brain. I'm trying to figure out how big of an emergency our mortgage is and develop the best strategy for paying it off.

Here's a brief background before I get into numbers. We're a family of five (parents in our mid-40s, three kids under 16) originally from the U.S. but now living in Europe. All except one member of the family has dual citizenship. We live in a small, pleasant city within walking/biking distance of everything. We employ a lot of Mustachian principles in life and lived entirely debt-free for years, until we finally purchased a condo six years ago. Now this one (large) debt is weighing heavily on my mind, especially because I've only recently had my eyes opened to the idea that being more conscious about our saving and financial planning will lead to a better future for all of us.

So, onto the details of the loan itself. We made what was possibly a poor choice to take out a loan in Swiss francs (CHF) even though our earnings are in euro (EUR). This was a popular financial move in several central and eastern European countries in the years up to 2008 because the CHF interest rates were significantly lower than EUR ones, and it was widely believed that the exchange rate between the two would not vary enough to make the exchange rate risk a huge limiting factor. (Also: all loans available in either currency were ARMs; only in the past couple of years have they started offering fixed-rate loans.) Well, once the financial crisis hit things started looking a lot different, and the major exchange rate changes have led to people having problems with these loans, ending up underwater and having higher monthly payments than they can afford. We've had no trouble affording our monthly payments, but I'm definitely uncomfortable with the situation especially now that I'm thinking it would be nice to pay off the loan early. (My perspective on long-term debt has changed a lot since we took out the loan, at which point I figured that the exchange-rate risk would be negligible over the entire 30-year loan period. Now I'm more interested in paying it off early.)

Here are the numbers on ours:

Purchase price: EUR 237,000 (we made a ca. 20% downpayment)
Current resale value: probably around EUR 220,000 to 230,000, but the real estate market here is very stagnant at the moment.
Amount financed: CHF 275,300 (=EUR 178,801 at exchange rate of 1.5397 in late Nov. 2008)
Terms: 30 years, variable interest rate, which has dropped every year so far and is currently at 4.81%
Current principle owed: CHF 248,450 (=EUR 206,628 at exchange rate of 1.2024 in late Nov. 2014)

As you can see, in EUR terms we owe EUR 27,827 more now than we did six years ago! And of course for most of the repayment period those francs have been more expensive each monthly payment than they were when we borrowed them. (In fact, there has been only one single month in which the exchange rate worked in our favor.) On the other hand, our interest rate has consistently been about 2% lower than it would have been for a EUR loan during the same time period.

I'm planning to go to the bank and talk to them about early repayment, and I expect them to tell me I'm crazy for even considering it because francs are so expensive right now. But the way I've starting thinking is this:

If we made a lump-sum payment of CHF 10,000 (EUR 8,316) it would save CHF 20,405 (EUR 16,970) in interest. If we do a lump-sum payment of CHF 20,000 (EUR 16,633) it would save us CHF 38,465 (EUR 31,990) in interest, which is already more than the current "shortfall" we face due to exchange-rate risk. So it seems like a good idea despite the currently unfavorable exchange rate.

Other considerations: interest rates are likely to rise again someday, and it's very hard to predict what's going to happen with the CHF/EUR exchange rate. I'm inclined to think it will stay "pegged" like it is now for some time to come. I need to make sure I understand all the fees the bank will impose on us for early repayment (they'll run the numbers for us), but I still expect it to be a good deal overall.

Our overall financial condition: our income varies a lot but is currently around EUR 58,000/year after taxes. We have about EUR 20,000 in savings and about USD 21,000 in TIAA-Cref funds (still more exchange rate risk!) We're not nearly at the rate of savings/investment we should be, but I'm aiming to change that as of now. Hence my consideration of the mortgage and whether to throw everything we have at wiping it out or whether we should also try to increase our investments too (and make some of them dominated in EUR!).

Any thoughts or additional angles to ponder?

-Z

[Chrissy]

So your interest rate is 4.81%, getting better every month, but, from the beginning of your loan to now, the exchange rate has moved against you by 30%.  So, by my estimation, your monthly payment costs you 25% (approx) more today than it did when you took out the loan.  Is that what you're seeing too?  If so, that's totally nuts. 

Long-term debt is supposed to be stable, and having a place to live is supposed to give you peace of mind.  Your situation doesn't meet these requirements.  Pay it off, or roll it over to a euro based mortgage if that's possible.

[aspiringnomad]

It sucks that their might be early repayment fees. Find out what those are, and if they're not too significant, I say go for it. The exchange rates burned you in the past, but going forward I might be more concerned about your interest rate risk. Either way, paying down the debt and reducing your exposure to those risks seems very sensible, again assuming the early repayment fees aren't too severe.

[Zarya]

So your interest rate is 4.81%, getting better every month, but, from the beginning of your loan to now, the exchange rate has moved against you by 30%.  So, by my estimation, your monthly payment costs you 25% (approx) more today than it did when you took out the loan.  Is that what you're seeing too?  If so, that's totally nuts. 

Yes, that's the case for now. But if the exchange rate swings the other way we could have an equivalent advantage (25% cheaper payments). I guess I had thought for a while that it was better to hang in there and wait for a better exchange rate before making any moves, but now I'm thinking that the interest savings from paying off early still make it worthwhile, even though we take the hit on the exchange rate.

It is also a lesson in why people shouldn't borrow money in currencies other than their income-earning one.

[Emg03063]

I'm no expert on the matter, but I imagine there must be a way to hedge your exchange rate risk by buying CHF futures or forwards or selling EUR futures in CHF.  Primer here:  http://www.investopedia.com/articles/trading/04/102704.asp

[Goldielocks]

You seem to recognize your first error -- taking on the exchange rate risk of a large debt, when your assets and income are in a different currency.

As the others said, you need to hedge your risk, the options route mentioned (as done by businesses) is one means, and the second is to have offsetting savings in Swiss francs.  e.g., if you had placed even 30% of the loan amount in CHF in your savings,  it may have been a good enough hedge, given the superlative mortgage rate.

Looking forward, this still may be a good option -- even if you expect EUR to rise (and your savings in CHF to fall), that would be a good thing, because the loan value decreases, and your income increases (relative to  it).   If CHF continues to climb (hard to know, isn't it?) then you have the "safeguard" of having CHF savings climb (albeit slower) than your debt obligation. 

The options route is similar, except it is simply paying for the option to buy out CHF on or before a certain date, at a pre-agreed price, in exchange for an upfront fee to buy that option.  It allows you to hedge by committing a small amount of money right now, without requiring large cash outlays, and protects your future downside, for an immediate payment cost.  If most people are betting the CHF will fall, an option to buy CHF at a HIGHER price in future should not be very expensive.  But you need to do your research.

So, one alternative to prepayment penalties, is to start stashing extra money into CHF currency, to be used in future if you need to refinance into EUR.
Another alternative is hedging  / buying currency options.

Yet another alternative is for one of you to gain employment that pays a good salary in CHF... but I imagine that if you do not live in that country, it would be hard to do.


At this point, you need to decide if further exchange risk is okay for you.   At what point do you trigger your "get out now" plan?   
What is the biggest loss that you are willing to undertake, and how fast can you trigger your "get out" plan?  What does that plan look like?  Be prepared today, even if the chance is low.

Good Luck!  I hope that things turn around for you.

[aspiringnomad]

From what I understand, CHF is effective pegged to EUR at this point with the Swiss National Bank claiming they'll do what it takes to ensure it appreciates no further. If you trust that claim, your downside currency risk is limited going forward, no? So you're more worried that you'll lose out on benefits from a possible EUR appreciation by prepaying, correct?. Seems speculative to me. Sorry, if I missed it, but are there any limits on the annual variability in your interest rate? If not, that's why I suggest focusing on that risk and prepaying.

[MDM]

If I understand correctly,
  - you are paid in euros
  - you have no savings in CHF, only EUR (ignoring the US$ amounts)

When you pay for living expenses (food, utilities, etc.) is that all paid in EUR or some in CHF?

If everything else in your financial life is based in EUR, it might help you to convert your loan terms to EUR.  Just talking spreadsheet now, not refinance - at least not yet. 

In other words, starting now (the past is sunk cost), what is your principal, length, interest rate and monthly payment for this loan?  You should confirm that Excel (or whatever spreadsheet tool you use) calculates the same monthly payment you owe, given the principal, length and interest rate.

If all the above assumptions apply, this might eliminate a few variables and make it easier for you to decide what makes sense.

[Zarya]

Thanks for the feedback, everyone.

Yes, we live in a country that uses EUR and it's unlikely that I'll start earning CHF any time soon. Many other people in this country are in the same situation with CHF loans (it turns out that our bank shut down those loans only one month after we got ours because they anticipated the problem).

I've thought of hedging and may still look into that further. I've actually made a bit of money by timing my EUR/USD exchanges well but have never dabbled in currency trading otherwise. The CHF/EUR pair is being held at the 1.20 floor right now by the Swiss Central Bank, but when (if!) economic recovery gets rolling here things will change again. So if we decide to keep paying for the remainder of our 24-year period we could well have years in which the exchange rate is an advantage to us. I've just kind of developed the itch to pay it off instead of worry about it any longer.

The amount of the prepayment penalty will also affect our decision (a new law states that banks can't charge these any more, but if the contract pre-dates the law they still can). I will meet with the bank this week. It's also possible to get them to further lower the interest rate (because we're on the LIBOR almost all of the interest they're charging us is their margin).

I'll also ask about rolling it over to a EUR loan but I think I'd rather not unless they offer us a good deal. I know some other customers (and lots of people in other countries) have done that so there is a way.

-Z