So you've got a yen to switch your mortgage? Think carefully

If Japanese interest rates are so low, surely it's worth switching to a yen-based mortgage? They do exist - Barclays offers one at a rate of just 1.56%, compared to its standard rate of 6.5%.

A rate of 1.56% means that someone with an interest-only mortgage of £150,000 will pay just £195 a month, peanuts in comparison with the £812.50 monthly payment for the same loan on a standard variable rate in Britain.

Unfortunately, seductive as the headline figures are, foreign currency mortgages are only suitable for a tiny minority of people who understand, and can afford, the huge risks that they carry.

The fundamental flaw in foreign currency mortgages is exchange rate risk. Say, for example, the pound weakened against the yen, falling from its current level of around ¥173 to the pound to ¥140. That would result in the £150,000 mortgage turning into £185,000. Sudden shifts of this magnitude are not uncommon in the foreign currency markets, and could leave a homeowner with a disastrous increase in the amount of capital to repay.

What's more, it is precisely what did happen when foreign currency mortgages first came into vogue in the late 80s and early 90s, when the gap between UK and overseas interest rates widened. Many borrowers were subsequently burned when the pound was ejected from the Exchange Rate Mechanism and fell sharply. Many of the mortgage products at the time contained a "stop loss" clause which forced the borrower to convert the loan back into sterling once the capital had moved so disadvantageously.

Of course, the exchange rate can shift in the opposite direction, and a borrower can gain from both lower interest rates and a fall in the sterling value of the loan. For example, if the pound strengthened to ¥200 from ¥173, a £150,000 loan would decline in value to £130,000.

Patrick Bunton at broker London & Country Mortgages says he always dissuades home buyers from taking out a foreign currency mortgage. "People got burned big time in the early 90s. I work in mortgages yet I certainly wouldn't feel comfortable about taking a currency risk on my home loan. The second that the exchange rate goes against you, you can see your mortgage go up by, say, 10% to 25%. How many people are prepared to accept that level of risk?"

He adds: "The people who come to us asking about a foreign currency mortgage are usually those who are most uninformed on exchange rates. The informed ones are foreign exchange dealers and the like, who if they do it tend to do it off their own back."

Barclays, even though it is the only major bank which offers yen-based mortgages, says it is at best a niche market for the highly sophisticated.

Spokesman Perry Jones says: "We will only allow someone in Britain to take out a foreign currency mortgage if they are paid in the currency of the mortgage. Our maximum loan to value is 65% [that is the borrower has to put down a minimum deposit of 35%] and we only offer interest-only rather than repayment loans.

"They tend to be aimed at the astute investor who is willing to accept the fluctuations in exchange rates and interest rates," he says.

Apart from yen mortgages, Barclays also offers US dollar-based loans at 4.09% and euro loans at 5.15%.

The switch to euro notes and coins across Europe in the New Year may spark greater enthusiasm for euro mortgages, but the exchange rate risk for British-based borrowers will remain. Last week Wim Duisenberg, governor of the European Central Bank, cut euro interest rates by 0.5% to 3.75%, compared to the 4.75% base rate at the Bank of England.

But borrowers may be surprised to discover that this does not translate into cheaper mortgages for house buyers on the continent, where the mortgage market is much less competitive.

Abbey National is the principal lender in the euro-mortgage arena, with a product based on the Euribor rate, currently charged at 5.94%. It is repriced every three months, and Abbey says it expects to be able to reduce the rate in November.

Where such a loan can be useful is when a British investor owns a property in, say, France or Spain, which is rented out locally. London & Country's Mr Bunton says: "If your rental income in Spain is in euros, it makes sense to borrow in euros. But if it is a second home that is not let out, or rented in sterling terms to other UK holidaymakers, then the mortgage borrowing should be in sterling."