Mortgage Term Review – January 2012



Term-AnalysisIt’s been quite a stretch since CMT’s last term analysis. Given the slew of precedent-setting rate changes lately, it’s high time we run another one.

For those in solitary confinement last week, the big news was BMO’s 2.99% 5-year Low-Rate Mortgage. It made every major newspaper and newscast in the country. Even the CEO of competitor ING Direct, Peter Aceto, found it compelling. He told the Toronto Star:

If you’re satisfied with everything else, take it, because 2.99 for 5-year money is a great rate…I had some of the people here look into it, and it’s definitely the lowest they’ve been able to find for as far back as it’s been tracked.

(Aceto went on to suggest that 2.99% was “unsustainable” from a profitability standpoint.)

In any event, say what you will about the limitations of BMO’s product (and there are many), but it sure did push down rates industry-wide. Here’s a look at how the recent rate changes impact mortgage terms:

Why “Term” Matters…

Term-ComparisonFor every 100 non-referral inquiries we get, perhaps 80% are “rate” focused. Probably less than 1 in 5 requests pertain to picking the right “term.”

Those numbers should be reversed. The reality is, the mortgage term you pick will have a far greater impact on your borrowing cost than the up-front interest rate.

The reason is simple. Your term determines the length of time you’re locked into a rate. That determines how long you’ll overpay or underpay, relative to all other available mortgage options.

The wrong term can get tremendously expensive if:

  1. Interest rates deviate markedly from your assumptions, or
  2. You need to break your mortgage early.

It therefore pays to make the right choice from the get-go.

Almost anyone can find a low rate by doing a little Googling. Picking the correct term isn’t so easy. For that reason, make an effort, do the research, get good advice, and nail the right mortgage the first time. Below you’ll find bite-sized term reviews to give you a running start.

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Shorter Fixed Terms…

  • 6-month Fixed (Approx. Rate: 2.89%)
    Half-year terms are useful for: a) short-term property holds, b) waiting out better variable-rate discounts, c) riding out low rates before locking in, and d) allowing you the opportunity of frequent re-negotiation. Home Trust is the 6-month rate leader at the moment. (By the way, Home Trust was brilliant in recently launching this term. It’s almost all alone in this segment.)
  • 1-year Fixed (Approx. Rate: 2.59%)
    A fitting alternative to a variable, assuming you want a variable and are suited to it. A 1-year is cheaper than a variable and it lets you secure a new rate in 8-9 months, after which today’s tight-wad variable-rate discounts may very well improve. If you live near Calgary, First Calgary has a tantalizing 2.39% one-year promo.
  • 2-year Fixed (Approx. Rate: 2.69-2.89%)
    Two-year terms looked better at 2.49% in the fall. Based on current pricing, they’re not worth the rate risk at renewal in 2014 (when rates are assumed to be higher). For most people, there’s more value in today’s 1-year fixed—thanks to the flexibility of renegotiating earlier.
  • 3-year Fixed (Approx. Rate: 2.89%)
    There’s no bargain here unless you need to break your mortgage prior to four years. For a measly 10 bps more you can get four whole years of rate protection.
  • 4-year Fixed (Approx. Rate: 2.99%)
    A flock of lenders (led by TD) launched 2.99% four-year deals in response to BMO’s 2.99% low-frills 5yr offer. In doing so, TD’s 4-year press release took a veiled shot at BMO, saying: “homeowners do not have to give up features and flexibility to get a great rate.” Given the choice of a 4-year term with maximum flexibility or a 5-year with heavy restrictions, the 4-year is better suited to most. Here’s the thing: Full-featured 5-year terms are now on the net for just 10-15 bps more, and the risk of rates rising 0.60%+ in four years is acute. Given that, it makes no sense to forgo the security of a 5-year for such small upfront savings. One thing in the 4-year’s favour is that people refinance 5-year terms in roughly 3.5 to 4.0 years on average. Consequently, a 4-year will  sometimes save you early termination penalties.

Longer Fixed Terms…

  • 5-year Fixed (Approx. Rate: 2.99%-3.19%)
    Low-frills 5-years at 2.99% are garnering all the headlines. While restrictive and unsuitable to the majority, they’re at least driving lenders and brokers to compete more aggressively. Here’s the rub. Any one of the following can easily outweigh the small payment/interest advantage of a low-frills mortgage:

    • Being able to pre-pay more than 10%
    • Being able to break the mortgage before maturity
    • Having the ability to refinance elsewhere before one’s term is up
    • Not having to pay an enormous posted-rate IRD penalty (which is common to the Big 6 banks…see this story from brokers Michelle Beet and Randy Cowling.)

Is it worth it to save $5.15 a month per $100,000? Not for anyone but a small minority. Full-featured 5-year terms are just 10-15 basis points more. You’ll also find that most 2.99% low-frills options are unavailable with HELOCs, 30- to 40-year amortizations, and/or rental applications—if those are important to you.

Incidentally, the venerable 5-year fixed is still winning popularity contests by default. That’s because people who put down less than 20% often cannot meet the government’s qualifying rate for a shorter or variable term. That leaves them with no other practical choice besides a 5- to 10-year fixed.

  • 6- and 7-year Fixed (Approx. Rate: 3.74%-3.89%)
    Now that they’re sub-4%, these terms are far less horrid than they once were. But they are no match for a 5-year or low-cost 10-year.
  • 10-year Fixed (Approx. Rate: 3.89%)
    When was the last time we saw a 10-year at 3.89%? Never. At today’s rates, it’s a dream for those wanting minimal rate risk for an entire decade. Historically, 10-year fixed terms have cost more than consecutive 5-year fixed terms 9 out of 10 years (See: 10-year vs. 5-year fixed). But, at 80 basis points, the spread above 5-year rates has rarely been as tight as it is today. That’s prompting some people to throw historical probabilities out the window.If you do take a 10-year, you’re guaranteed to pay about $3,800 more per $100,000 of mortgage in the first five years. That’s the price of rate “insurance.” Five-year fixed rates would have to climb close to 2% in 56 months for a 10-year to beat two consecutive 5-year terms. (Assumes equal payments and a 25-year amortization) Coming out of a recession, history proves that is possible. A two percent rate jump also happens to be less than that projected by major economists (who just might get a long-term forecast right, one of these days.).One benefit of a 10-year is that lenders let you escape (break the mortgage) after five years for just a 3-month interest penalty. So if 5-year rates are unexpectedly below 3.89% in 56 months, you can switch mortgages relatively cheaply.

    10-year terms are also used by:

    • Income property investors who write off interest (Long-term financing helps predict monthly cash flows much further out.)
    • Young homebuyers or those who cannot comfortably withstand a potential 3% rate increase in five years.

Variable Terms…

  • 5-year Closed Variable (Approx. Rate: 2.80%)
    The heyday of variable-rate mortgages has passed, albeit temporarily. Six months ago people were getting prime – 0.85% or better. Today, borrowers are fed prime – 0.20%. That said, wider discounts may return after things settle down in Europe. As a result, those gung ho about variables should check out 6-month or 1-year terms. Just keep in mind that rates will escalate at some point, in which case ~3% is a pittance for five years of fixed-rate security.Whatever you do, don’t get mesmerized with the “research” that says variables beat fixed mortgages 88-90% of the time. The odds of that being true today—given Canada’s ultra-low overnight rate and tight gap between terms—are drastically reduced. (Here is that fixed and variable rate research.)
  • 3-year Closed Variable (Approx. Rate: 2.80%)
    Ditto.
  • 5-year Capped Variable (Approx. Rate: 3.10%)
    Someday, lenders might decide to set a fair cap rate (i.e. rate maximum). Until then, these products are just gimmicks.
  • Open Variables (Approx. Rate: 3.80%-4.00%)
    Open mortgages are temporary solutions and you’ll pay a premium for their flexibility. If you’re considering an open, look at a much cheaper 6-month fixed as an alternative.

Other Terms and Features…

  • 5-year Cash Back Down Payment (Approx. Rate: 5.29%)
    Most people considering these mortgages are pretty desperate to buy, so banks apply strict underwriting and posted 5-year fixed rates. Here’s a radical thought for those without 5% down:  Rent and save! Bank away a down payment, closing costs and a 4-6 month emergency fund. Home ownership without a financial cushion is like walking a tightrope without a net.
  • 5-year Cash Back Refinance (Approx. Rate: 5.29%)
    Despite their posted rates, the actual effective rates on cash-back mortgages are not as horrendous as you’d think. (See: Cash Back Refinances…) Thanks to the new mortgage rules (with 85% loan-to-value limit on low-cost refis), cash-backs are one of the few options left for those needing a 90% LTV refinance. If you require the maximum possible LTV and cash back, National Bank’s 5.5% cashback mortgage or FirstLine’s discounted 5% “LoanCloser” are market leaders.
  • 5-year No-Frills (Approx. Rate: 2.99%)
    At present, the piddly savings on no-frills mortgages isn’t worth the flexibility you give up. Note: (“No-Frills” is not the same as “Low-frills,” which is what you’d call BMO’s 2.99% offer.) With no-frills mortgages you’ll often get 0-5% pre-payment privileges instead of 10-30%. In addition, you’ll sometimes:

    • be banned from switching lenders or refinancing elsewhere mid-term
    • pay “reinvestment” fees if you break early
    • be without online account access (if that’s important to you)
    • pay higher breakage penalties.

    All of this to save $10-15 a month on a $250,000 mortgage? No thanks.

  • Readvanceables (Approx. Rate: Varies)
    If you’ve got 20%+ equity, take a good look at a readvanceable mortgage. Readvanceables make you liquid, and you can’t put a price on liquidity—especially when emergencies and investment opportunities arise. The main downside is the inability to switch lenders without paying legal fees (~$600-800). That said, sometimes a new lender will pay them for you.
  • Open HELOC (Approx. Rate: 3.50-4.00%)
    HELOCs are priced more than 60 bps above most closed variables. Therefore, don’t borrow from a HELOC unless you plan to pay it off quickly, need interest-only payments, or want to utilize interest offsetting. If you’re planning to borrow a large amount and pay off less than 20-25% of your mortgage each year, save money and take a readvanceable 1-year fixed instead.
  • Hybrid Mortgages (Approx. Rate: Varies)
    A hybrid mortgage is part fixed and part variable, and/or part long term and part short term. Hybrids give you rate diversification, which makes a degree of sense since no one knows how high rates will be in five years. The problem is, variable rates aren’t so hot right now. If you do go hybri, choose the same terms for each portion (e.g.  a 5-year variable and a 5-year fixed). If you instead get part short-term and part long-term, the lender may be less motivated to give you a great rate when the short-term portion matures (because the lender knows you’re locked in with them on the longer-term portion).

Mortgage-Rates-3Street Rates: The above rates reflect deeply-discounted fair market rates that you’ll find on the street. They’re sampled from lender websites, broker rate sheets, various rate aggregation websites, bank branch representatives, bank mortgage specialists and broker websites. In general, you’ll do very well for yourself if you can find rates in these ranges. These rates are current as of January 18, 2012 at 11:00pm PT.

Exceptions: Only nationally-available rates are quoted here. There may be better rates on a regional basis. This information applies to well-qualified borrowers with provable income and strong credit. Pricing may be higher or slightly lower depending on your circumstances (such as rate hold period, mortgage features, qualifications, etc.). Broker and bank “discretionary” rates vary widely by branch and/or mortgage adviser. Rates are as of today and subject to change. Always contact a mortgage professional for a quote specific to your situation.


The Big Disclaimer:  There are a million and one exceptions to everything above, and market conditions change almost daily.  Therefore, be wise and have a mortgage professional compare these options based on current rates and your personal circumstances.

Above all, remember that these opinions are just that. They are not recommendations or advice. Qualifying is always contingent upon approved credit. All information is based on present market expectations, the market rates identified above, and current economic forecasts (which are subject to error)—all of which may change drastically without notice. These opinions are intended for mortgages on owner-occupied properties only.


Rob McLister, CMT

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Comments

  1. Comment avatar

    Nicolas    

    Amongst all your great posts, this one deserves an Oscar. Thanks!

     
  2. Comment avatar

    Jeff Norris    

    What an incredible post – thank you, Rob. This really drives home how many different products there are out there. I get the impression that when most Canadians hear the word ‘mortgage’ they immediately think ‘5 year fixed’. Your post is a great reminder of all the options available in the market and how important it is to consider term length, prepayment options, and other conditions.

     
  3. Comment avatar

    banker in an ivory tower    

    Nice! Excellent overview Rob!
    With the array of mortgages to select from today and the wide differences between just lenders and their offerings (standard vs. collateral mortgages, varied terms & conditions, different IRD calculating methods, varied service levels….etc etc etc), picking the right mortgage has never been more confusing.
    Every borrower’s needs and expectations are different. A good professional mortgage advisor is worth their weight navigating such a mine field.

     
  4. Comment avatar

    CUMortgage Advisor    

    Thanks Rob, this is a great overview of the many mortgage products out there.
    Goes to show that even though 80% care about the rate, it’s important to know the term and conditions of the products.
    Knowing your client’s needs is the key to finding the best mortgage out there for them.
    Thanks again.

     
  5. Comment avatar

    average joe    

    terrific posting rob….spells out all the options…best one i’ve read yet…

     
  6. Comment avatar

    John    

    Great article!!
    Can you explain how posted-rate IRD penalties are calculated, as referenced in the article from brokers Michelle Beet and Randy Cowling. They give numbers without referencing how they calculated the penalties.

     
  7. Comment avatar

    @mysmartmortgage    

    Thanks Rob. Another wonderful post.

     
  8. Comment avatar

    Raj    

    Re: IRD on a ten year term, is it correct to assume that if you break the mortgage in the first five years, the IRD would be calculated on the full ten year term of the mortgage?

     
  9. Comment avatar

    Charlie    

    Great post Rob in particular the 5 year fixed “no frills” item. “Lost” one to the big banks 2.99%, when we explained the no frills caveats they took offense assuming we were just trying win them back by any means, upon review, they came back!

     
  10. Comment avatar

    Brian Poncelet CFP    

    Hi Rob,
    Happy New Year!
    The question to ask what will happen to real estate
    If rates go up? Right now the economy runs on real estate.
    Like the US once that blows it will take years to recover.
    Debt is at an all time high so the party must continue.
    Cheers,
    Brian

     
  11. Comment avatar

    Brian Poncelet CFP    

    Hi Rob,
    Happy New Year!
    The question to ask what will happen to real estate
    If rates go up? Right now the economy runs on real estate.
    Like the US once that blows it will take years to recover.
    Debt is at an all time high so the party must continue.
    Cheers,
    Brian

     
  12. Comment avatar

    Brian Poncelet CFP    

    Hi Rob,
    Happy New Year!
    The question to ask what will happen to real estate
    If rates go up? Right now the economy runs on real estate.
    Like the US once that blows it will take years to recover.
    Debt is at an all time high so the party must continue.
    Cheers,
    Brian

     
  13. Comment avatar

    Robert McLister    

    Thanks for all the incredibly nice comments everybody! Glad the review came in useful. Cheers….Rob 🙂

     
  14. Comment avatar

    Rob Campbell    

    Rob,
    This was an amazing post.
    So much insight into a huge amount of options.
    You totally proved that this whole “best rate” war needs to be fought with education, not with slashed commissions.
    Keep it heavy with the awesome sauce Rob!! 🙂

     
  15. Comment avatar

    Greg Williamson    

    This post should be bookmarked by all mortgage professionals.
    Great Job Rob, what an incredible amount of work.

     
  16. Comment avatar

    Observer    

    Competition is the key.
    More govt regulation on BIG banks !

     
  17. Comment avatar

    Mitch    

    Raj – IRD on a ten year term is calculated on the remaining years of the mortgage. For example, If you are three years in, the IRD would be based on seven years.

     
  18. Comment avatar

    Raj    

    Thanks. So although once you’re in month 61 of your ten year term you can exit the mortgage by paying three-month’s interest, if you try to exit in month 59 you could be on the hook for five years’ worth of IRD penalties. Risky.

     
  19. Comment avatar

    Jonathan Jones    

    This is the best article on mortgages I’ve read in months, if not longer. A lot of food for thought for anyone, including me, nearing the end of a mortgage term and preparing to renew. Nicely done!

     
  20. Comment avatar

    Appraiser    

    Kudos Rob!
    Hands down the best article I have ever read on mortgages.
    Thorough, informative and very helpful.
    Thank-you.

     
  21. Comment avatar

    ben10    

    Thanks. So although once you’re in month 61 of your ten year term you can exit the mortgage by paying three-month’s interest, if you try to exit in month 59 you could be on the hook for five years’ worth of IRD penalties. Risky.

     
  22. Comment avatar

    Robert McLister    

    Thanks again everyone for the greatly appreciated feedback!!
    Ben, Once you pass the 60-month mark you can break for just 3-month’s interest. If you’re in month 59 you’ll often want to hang on for dear life till month 60. But there are exceptions. It totally depends on the lender and rates at the time. Best bet: Call your lender for an exact penalty quote.
    Cheers…
    Rob

     

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