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Mortgage Term Review

Updated: March 15, 2010

Key developments since our October 29, 2009 update:

  • Talk of Bank of Canada rate hikes has intensified
  • Bond yields have been in a sideways trading range, keeping fixed rates near their all-time lows
  • Variable-rate discounts have increased
  • 5-year fixed mortgage spreads (the difference between lenders’ fixed rates and their cost of funds) have narrowed dramatically
  • HELOC rates have remained stubbornly inflated

Why Is Your Term Important?

Best-Mortgage-RatesPicking a mortgage is like buying a racehorse. It’s an expensive purchase and good advice can save you a lot of money.

Almost anyone can find a low rate just by checking the Internet. What’s not so easy is picking the right term. 

The term you choose often has a far greater effect on total interest costs than the up-front interest rate. That’s because the wrong term can be costly if interest rates deviate from your assumptions, if your finances change, or if living plans require you to break the mortgage.

Take some time to determine the proper term for your time horizon and risk appetite. Below you’ll find bite-sized reviews of several different terms to give you a running start.

Popular Fixed Terms…

Here’s a breakdown of the most popular terms, as of today:

  • 1-year fixed:  If you look hard you’ll find mortgage planners quoting one-year rates just below prime. Yet, with variable-rate discounts improving significantly, 1-year terms are no longer as compelling as they were in the fall.  If you do take a 1-year, get one that’s convertible at any time (to either a fixed rate, or to a fixed or variable rate).
  • 2-year fixed:  Two-year terms don’t provide enough bang for the buck. Why risk a 2-year term at 2.75% when you can get a variable rate for a point less?
  • 3-year fixed:  You’ll save a chunk of interest over the first 36 months compared to a 5-year fixed. The trade-off is more risk in years 4 and 5. If fixed rates rise over 1.5% in the next few years (and many think they will), you’ll likely do better with a 5-year term. 
  • 4-year fixed:  Four-year mortgages aren’t cheap enough to justify the risk in year five. That said, if there’s a chance you’ll break your mortgage in four years (people refinance every 3.5 years on average), a 4-year fixed might lessen or eliminate your mortgage penalty.
  • 5-year fixed:  People choose 5-year fixed mortgages because they’re afraid of big rate increases. As it turns out, that fear may be well-placed considering our current position in the economic cycle (and in history for that matter). With most “experts” forecasting rate hikes in the 2nd half of 2010, choosing a 5-year term is the best way to minimize stress.

Longer Fixed Terms

  • 7-year fixed:  7-year mortgages cost over 1.25% more than 5-year terms, for just two more years of rate assurance. As a result, they don’t sell very well. If you’re that concerned about risk, take a 10-year for the same price.
  • 10-year fixed:  The decade mortgage is available for just 5.15% or so. That’s not too far from its record low. What’s more, you can get out after 5 years without paying a dreaded IRD penalty. On the other hand, for a 10-year to beat a 5-year, rates would have to go up drastically by the time your 5-year term matured. If you set your 5-year payments to the same as a 10-year, 5-year rates would have to jump over 6% before you’d save more in a 10-year term.  That possibility is remote and the rate premium on a 10-year fixed is therefore an expensive form of insurance.

Variable Terms…

  • 5-year closed variable:  Prime – 0.40% can now be found in a half dozen places.

Barring any shocking economic developments, prime rate will not go lower.  Therefore, most people are looking at variable rates with one of two things in mind:

  1. They want to time the market (enjoy low rates in the short term and lock in before fixed rates go up)
  2. They think rates are going up about 2.50% or less in the next five years

If your plan is the former, be warned.  You can’t rely on your lender or broker to warn you before rates go up. It’s way too easy to be wrong or late when locking in. 

If you plan to convert your variable to a fixed rate, taking a 3- to 5-year fixed term from the outset may be the better choice. Than you don’t need to worry about timing, and you won’t be stuck with your lenders “conversion rate” when locking in.

As a very rough rule of thumb, if rates rise less than 2.50% over five years, you’d probably save more in a variable than a 5-year fixed.

  • 3-year variable:  3-year terms let you renegotiate sooner–which is good if you might need to break your mortgage in 3 years, or if you think variable discounts will improve in 36 months. In the 3-year market, you can find rates as low as prime – 1/2% (if you don’t need pre-payment options) and prime – 0.40% (if you do).
  • 1-year variable:  If you think variable rates will get a lot better in 12 months and you don’t mind renegotiating so soon, a 1-year might fit. Just don’t pay more than 1/10% more for it.
  • 5-year capped variable:  You’ll get 2.90% today and never pay over 5.25%. That’s dandy from a marketing standpoint, but the numbers don’t make sense. Rates would have to jump roughly 5% in the next few years (and stay there) for a capped variable to save you money. If you’re worried about rising rates that much, you shouldn’t be in a variable.
  • 5-year open variable:  Opens are temporary solutions and you’ll pay a premium for their flexibility. Unless you’re going to terminate early, save one percentage point and choose a closed variable instead.  Remember, closed variables are portable, and they ‘only’ have a 3-month interest penalty. Even if you have to break the mortgage in a year, you’ll come out ahead in a closed variable.

Other Terms and Features…

  • 5-year Cash Back Down payment:  You can now find 5-year cash back down payment mortgages under 5% (as of March 15, 2010).  That’s made their total cost more comparable to the insured 100% financing mortgages of yesteryear (essentially because you’re getting the down payment for “free.”). That said, you will pay a lot more interest. Moreover, if you can’t put down 5%, shouldn’t you rent and build up a down payment and an emergency cash buffer?
  • 5-year no-frills:  If there’s any chance you’ll need over 5% annual pre-payment privileges, you’ll be sorry for choosing a no-frills mortgage. If not, you’ll save a smidgen (0.15% or so) over the best regular 5-year terms.
  • Readvanceables:  Still love’em. They’re the “must have” mortgage if you’ve got 20%+ equity. Readvanceables make you liquid, and you can’t put a price on liquidity. More…
  • Open HELOC:  HELOC rates have remained stubbornly high for months now. The cheapest lenders have secured LOC rates at or near prime + 0.50%. That said, unless you plan to pay off over 20% of your mortgage in any given year, go with a variable readvanceable instead.  It’s somewhat similar in flexibility, but cheaper.
  • Hybrids:  A hybrid mortgage is part fixed and part variable (and/or part long term and part short term). Hybrids offer a nice degree of rate diversification.  If you can’t decide between a fixed or a variable, check them out.  Just remember, if you think prime will rise over 2.50%, a straight 5-year fixed term is the better option.  Also, if you’re getting part short-term and part long-term, the lender may be less motivated to give you a great rate at renewal on the shorter term. That’s because the lender knows you’re locked in with them on the longer term.


The Disclaimer:  There are a million and one exceptions to everything above and market conditions change almost daily.  Therefore, do yourself a favour and consult a mortgage planner for a current comparison of the options. Remember, 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 conditions, rates and expectations–each of which may change without notice!