Think Outside the Bun

tasty-tacos-are-like-3-year-fixed-mortgagesThat is Taco Bell’s slogan.  It’s meant to remind us that fast food doesn’t end with hamburgers. Tacos are pretty tasty in their own right.

In the lending world, the closest equivalent to “the bun” is the 5-year fixed mortgage. Like hamburgers are to fast food, the 5-year fixed is to mortgages. It’s been the most popular term in Canada for years.

Yet, despite its prevalence, qualified borrowers owe it to themselves to think outside the 5-year fixed. A little extra risk can sometimes yield a lot more reward.

Fixed 5-year mortgages are especially popular in uncertain/rising rate markets (like today’s). People who can’t afford rate risk, and those who cannot qualify for shorter terms, often choose a 5-year fixed by default.

Even individuals with rock-solid financial resources frequently gravitate to 5-year terms. Much of the time that’s because they don’t want to overthink the safety of a longer-term mortgage. In other cases, it’s because no one has ever shown them how much 5-year fixed terms really cost over the long run.

No matter how popular 5-year terms are, however, mortgages are not a one-size-fits-all proposition.  For those who can stomach the chance of higher rates at renewal, various compelling alternatives exist. One happens to be the 3-year fixed.

Lenders like Merix Financial, HSBC, and others still have three-year rates in the 3.35% range or better. That’s 59+ basis points below current 5-year pricing.

At those rates, (from a purely mathematical and hypothetical perspective) the 3-year fixed performs better in our internal simulations than any other term, be it a variable or a 1, 2, 4, 5, 7 or 10-year fixed.1

With major banks forecasting a 2% rate hike in 24 months, 3-year fixed mortgages model even better than variable-rate mortgages (primarily because of the 3-year’s low rate and its 36 months of rate-hike protection).

This doesn’t mean a 3-year will definitely save you more money than any other term. It just means they offer very good value with decent odds of interest savings.

amortization-comparisonOn a $300,000 mortgage with a 25-year amortization, a 3.35% three-year will save you about $5,130 over a 3.94% five-year fixed. That’s over 36 months.

After 36 months, you can move into any other term you want (e.g.,  a 1-year fixed, variable, or another 3-year fixed). As long as your rate at renewal is about 5% or less, you’ll come out ahead of today’s 5-year fixed.

A few other points about 3-year terms:

  • You can make your 3-year fixed payment equal to a 5-year fixed payment, thus shrinking your amortization even faster.
  • People tend to refinance 5-year terms roughly every 3.5 years on average. Three-year terms let people out without a penalty just before many of them are getting ready to renegotiate their mortgage.

The “optimal term” (if there is such a thing) changes as rates fluctuate and as borrowers’ finances change.

All things considered, however, the three-year fixed is the sweet spot of the mortgage market at this particular point in time.

Sidebar:  Economist rate forecasts are subject to error so they are only a rough guide. Your financial resources and risk sensitivity are paramount when choosing a term. Always consult a mortgage professional for advice specific to your circumstances.

1 Based on amortization comparisons using major Canadian economists’ published 2- and 5-year rate forecasts, historical rate spreads, and deeply-discounted rates for all fixed and variable terms.

Rob McLister, CMT

  1. Still a big advocate of the Inflation Hedge ARM Strategy. Taking the Variable at 2.25% and setting the payment based on the 5yr fixed rate for substantial paydown and interest savings, even with the pending rate increases built into the model. Pay yourself the spread, not the bank!

  2. Hi Rob,
    I am a big fan of your calculations as this is one place they are done properly. Sad to say, but that is rare.
    If you give your 3.35% rate the same payment as the 3.94% rate the difference after 3 years is $5,299. Having the same payment eliminates any time value of money issues.

  3. >> People tend to refinance 5-year terms roughly every 3.5 years on average.
    Do you think that will continue to be true in a rising rate environment though?

  4. My opinion, I think it will hold true (perhaps even decrease) for 2011, when the rates start to level I think there will be more people taking their 5 year right to term.
    Jeff Aikman

  5. not everyone refi’s just for a lower rate. Sometimes they just need the funds. It would be worse if they were also paying a penalty to get out of their 5 yr term

  6. It has always been the trend. 70% of consumers who lock for 5 years never end up serving the full term, much to the delight of financial institutions. I think many people simply refuse to think outside the box and realize that it makes sense to go for a shorter maturity unless you’re extremely conservative with your finances. This way consumers can evaluate their mortgage options more frequently. The argument that locking the rate for the longest time is the best defense against rising rates is nonsensical unless there’s hyper inflation as that “defense” comes at a premium. Moshe Milevsky wrote an interesting article this morning at Moneyville that aims to clarify this very issue. The reality is we just can’t predict how high interest rates would head even in an environment of rising rates. Ultimately everyone has to renew their mortgage, so if you happen to fall in a time period when rates are high, your options are rather limited. Milevsky argues that unless you’re up to your neck in debt, most consumers are paying an expensive premium for a fixed rate mortgage. You can currently obtain a deeply discounted adjustable rate mortgage for 2.25%. Compare that with a 5-year fixed rate at just under 4%. That 170bp difference is huge. Even a 50bp difference, compounded over time, translates into thousands of dollars in savings, which is the point Rob is trying to make. In today’s environment, that approach makes more sense.

  7. Hi ls,
    Rate-driven refis will likely tail off a bit, yes…as will high-ratio debt consolidation refis (due to the new 85% loan-to-value limit). People will still have various other reasons to refi, but as you suggest, the average 5-year fixed holding period will probably tick up a bit.

  8. Hi Scott,
    Thanks for the post. That’s definitely a good plan compared to just making regular variable payments. We’ve run the numbers on this scenario as well and the 3-year fixed still performs better in our simulations, given the above assumptions.
    That said, it’s worth stressing again that reality will deviate from the assumptions. As a result, even though one strategy may perform better on paper, it often comes down to how much “security” or flexibility the borrower wants to pay for.

  9. Great article at the perfect time. I am currently cashing out a (foolishly advised) 10 year mortgage on my condo (after 3.5 years!), and purchasing a house which will be completed in 3 months.
    I currently have a pre-approval on a 5 year term through PC (at 4.22%), and the 3 year fixed is currently at 3.64%.
    I have zero debt, so would it be ideal to go with the 3 year fixed? Thoughts, anyone?
    New mortgage will be roughly 185,000.
    I most certainly can handle the possibility of rates being higher at maturity/renewal in 3 years, as I could just continue to renew at shorter terms/lower rates at any rate, correct?
    Sounds like the 3 year is the best way to recoup some of that foolish 10 year term I took (which was ay 5.85% AND $6000 to cash out).
    Any advice would be great! Love the site! Been checking it out for years!

  10. BUD
    I suggest u think like an investor …. u can afford to with only 185k principal….
    Go variable at 2.25, keep the same amort period u contemplated, and enjoy all the benefits to come, not only for the next three years, but for the life of your mortgage using the variable discount strategy….
    also, focus on the sweet discounted rate tied to prime…. this looks like the wave of the future, all lending trends considered !!! History is on your side with this strategy! I will run the numbers for u 3 years from now!!!!!
    Oliver Teekah

  11. Hi Bud,
    Thanks for the post. Once you’re 30 days from closing, shop around a bit and/or have a broker help you do it. You might be able to find a better deal. In fact, you definitely could if you were closing in the next few months.
    Also keep in mind that some PC mortgages have refinance/switch restrictions in the first three years.
    As for 3yr vs. 5yr, any good mortgage advisor can do some quick Q&A to make that recommendation. We don’t do it on the forums because we can’t get all the info we need to advise you. That said, it sounds like a 3yr is definitely worth investigating in your case.

  12. Hi Rob,
    I am wandering what fee are associated with transferring mortgage as is, i.e. the same amount and the same amortization period, from one financial institute to another. Does it depends on bank/ credit union? Can I choose notary or lawyer myself or it is dictated by bank? Can bank process the documents without a lower if mortgage transferred “as is”?

  13. Bud, who advised on a 10 year term?? In the 10+ years I have been doing mortgages I have only ever had one client request a 10 year term and i tried my hardest to talk him out of it. 3 years later when he wanted out the IRD was huge and he later said to me ” I should have listened”
    I think the 3 year term is a great value, however the 2.25 variable in my opinion is the best value on the market today. Set your payment the same as the 3 or 5 yr fixed and watch the savings transpire.

  14. We’re looking for a mortgage and we’re torn between fixed and variable. Given your post about the 2.25% variable I’d be curious to know your views on prime rate. How high do you think it will go, and when do you think prime will start and stop going up?
    Thanks in advance.

  15. Hi Alex,
    If it’s a straight switch of a regular mortgage you’ll often pay nothing but your existing lender’s discharge fee.
    If any of the following are true, then it’s possible that you’ll have to refinance to change lenders (which involves legal/registration costs):
    * Your mortgage is a collateral charge or a readvanceable mortgage, instead of a standard charge
    * You’re transferring into an open, 1- or 2-year fixed (some lenders don’t pay switch costs for shorter terms)
    * Your old lender is not on your new lender’s “free switch” list
    * You want to use your own lawyer to close instead of the lender-appointed closing company (lenders commonly use title companies to close, like FNF or FCT)
    * Your loan amount, amortization, or loan-to-value is increasing

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