What different types of interest rates are and why they matter

The Hong Kong Monetary Authority (HKMA) raised its base rate by 0.25 percentage points on Thursday following the US Federal Reserve’s overnight move.

In announcing the decision, HKMA chief executive Norman Chan Tak-lam reiterated his warning to Hong Kong home buyers that mortgage rates will rise in the near future.

How would the change in base rate affect your mortgages?

Here are some key concepts that would help you understand the impact.

Hong Kong interbank offered rate (HIBOR)

Banks borrow and lend money between each other in the interbank market in order to manage liquidity and meet the reserve requirements by HKMA.

The interbank rate is the rate of interest charged on short-term loans made between banks. Obviously, the Hong Kong Interbank Offered Rate (HIBOR) refers to the rate of interest charged on Hong Kong dollar loans by banks. The short-term loans can range from overnight to one year.

Discount rate

Banks would also take overnight loans from the HKMA as secured loans, which helps reduce liquidity problems for banks and assists in assuring the basic stability of financial markets.

The facility through which banks can borrow Hong Kong dollar funds overnight from the HKMA is called “discount window”.

Discount rate refers to the interest rate charged to banks for loans received from the discount window.

Base rate

Base rate is the interest rate set by the HKMA for lending to other banks, used as the benchmark for computing the discount rates.

There are two ways to set the base rate:

Option 1– Fifty basis points above the prevailing US Fed funds target rate (the interest rate US banks charge other banks for overnight loans).

Option 2 – The average of the five-day moving averages of the overnight and one-month HIBORs. Whichever option has higher rate, the HKMA will pick that as the base rate.

The HKMA announces the base rate every day before the interbank market opens in Hong Kong.

And here’s how these rates could affect you.

Mortgage plans in Hong Kong are divided into two main categories: a prime rate-linked plan or a HIBOR-linked mortgage plan.

Prime rate

The prime rate is the average rate of interest charged on loans by commercial banks to private individuals and companies.

The prime rate is set by banks individually but largely affected by the base rate. There are two types of prime rate in the market, the high prime rate and low prime rate.

High prime rate: 5.25 per cent – usually used by small to medium sized banks.

Low prime rate: 5 per cent – usually used by bigger banks

Prime rate-linked mortgage

Prime rate-linked mortgage rate = prime rate minus the interest rate that a bank offers you

For example, the bank is using the 5 per cent low prime rate. If it offers you a best interest rate 2.35 per cent, your mortgage rate will be 2.65 per cent.

The prime rate has been held steady since 2008, which makes your interest expenses relatively more stable.

HIBOR-linked mortgage

HIBOR-linked mortgage rate = HIBOR plus the interest rate that a bank offers you

For example, the current HIBOR is 0.15 per cent and the bank rate is 2.5 per cent, making your mortgage rate to be 2.65 per cent.

But when HIBOR rises, you may need to pay a higher mortgage rate.

HIBOR plans are renewed over three-, six- and 12-month periods during the loan’s tenure, and the interest rate will be maintained during that specific period.