Mortgage Term Review – May 2010

Updated: May 25, 2010

Key developments since our March 15, 2010 update:

  • The Bank of Canada has prepped the market for its first rate hike in almost three years.
  • Long-term fixed rates have started their ascent.
  • Variable-rate discounts have improved yet again.

Why Is Your “Term” Important?

 

Best-Mortgage-RatesThere’s an old saying: “The lowest rate will save you hundreds, but the wrong term can cost you thousands.”   

 

Whoever came up with that understood that one’s term can have a far greater impact on interest cost than the up-front interest rate. That’s because your term determines how long you’re locked into a rate–in other words, how long you’ll overpay or underpay, relative to other available options.

 

The wrong term can get mighty expensive if interest rates deviate from your assumptions, or if you need to break your mortgage early.

 

Almost anyone can find a low rate by browsing the Internet. What’s not so easy is picking the right term. Take some time, get good advice, and nail the right term the first time. Below you’ll find bite-sized term reviews to give you a running start.

 

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Popular Fixed Terms…

Here’s a breakdown of the most common mortgage terms:

  • 1-year fixed:  If rates rise as economists expect (see: mortgage rate forecast), then a deeply discounted 1-year term is mathematically a good alternative to a variable. At the end of the term, one can then move into another 1-year, or consider a variable.
  • 2-year fixed:  The best 2-year terms are right behind consecutive 1-year terms in hypothetical projected cost. Two-year mortgages also save you the hassle of renewing again in 12 months.
  • 3-year fixed:  You’ll save a whack of interest over the first 36 months compared to a 5-year fixed. The trade-off is more risk in years 4 and 5. That said, a 3-year term followed by two one-year terms (for example) outperform a 5-year fixed, based on current rate forecasts.
  • 4-year fixed:  At today’s rates, 4-year mortgages are a waste of time unless you plan to break your mortgage in four years (people refinance every 3.5 years on average).
  • 5-year fixed:  Insurance rarely comes cheap, and five years of rate security will cost you a bundle up front.  If short-term rates rise more than expected however (i.e.,  over 3.00-3.25%), then this conservative play will pay off.

 

Longer Fixed Terms

  • 7-year fixed:  The spread between 5– and 7-year terms has narrowed considerably, but not enough to make 7-year mortgages compelling. If you’re that concerned about risk, take a 10-year for 40 basis points more, and get three more years locked in.
  • 10-year fixed:  The decade mortgage is now available in the low to mid-5% range. Some consider that a pittance for 10 years of knowing your payments. What’s more, 10-year terms let you 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 over three percentage points by the time your 5-year term matured. We haven’t seen any reputable analysts predicting long-term rates to rise that much in 60 months. What’s more, history has shown that 9 out of 10 times, 10-year fixed terms cost more than consecutive 5-year fixed terms.

Variable Terms…

  • 5-year closed variable:  Prime – 0.50% is everywhere today (don’t let advertised bank rates fool you). If your bank or broker isn’t offering this rate, find another bank or broker.

Remember this though:  Prime rate will start its rise from the bottom in the near future.  Therefore, most people taking variables are betting that prime won’t rise more than 3.25% (the “breakeven” point between 5-year fixed and variable terms).

 

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

  • 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 – 0.55%.
  • 1-year variable:  If you think variable discounts will improve considerably in 12 months, and you don’t mind renegotiating so soon, a 1-year variable is an option. On the other hand, a 2-year fixed may be even better (if you buy into economists’ rate hike forecasts).
  • 5-year capped variable:  Two words: stay away. More…
  • 5-year open variable:  Opens are temporary solutions, and you’ll pay a premium for their flexibility. Remember, closed variables are portable, and they only have a 3-month interest penalty. Even if you break a closed variable in 10 months and pay the penalty, you’ll still usually come out ahead versus an open.

Other Terms and Features…

  • 5-year Cash Back Down payment:  At posted 5-year rates, these are mortgages for the desperate, If you can’t put down 5%, rent and build up a down payment.
  • 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 (0.15-0.25% or so) over the best full-featured 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:  Home equity line of credit rates have remained stubbornly high for months now. The cheapest lenders price them at or near prime + 0.50%. That said, if you’re planning to borrow a large sum and pay off less than 20% of your mortgage each year, save money and choose a closed variable readvanceable.
  • Hybrids:  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 sense since no one knows how high or low rates will be in five years.  Just remember, 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 short-term portion. That’s because the lender knows you’re locked in with them on the longer-term portion.

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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 professional 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, current economist forecasts (we do not predict rates), and today’s rates and expectations–each of which may change drastically without notice!

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