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10-Year Terms: More Taste, Less Filling

10-year-fixed-mortgageWith the recent dip in long-term funding costs, lenders are finally sharpening their pencils on 10-year mortgage pricing.

Decade-long rates haven’t been this cheap in virtually forever.

Some brokers are quoting as low as 4.34% today, whereas most lenders were over 5% last quarter. (Not that long ago, 4.34% was considered good for even a 5-year rate, let alone a 10-year.)

With 10-year mortgages going “on sale”, we did some calculations to see how they stack up against the most popular term, the 5-year fixed.

Looking back through history, 10-year terms have rarely come out on top. If you opted instead for two consecutive five-year fixed mortgages, you would have saved money roughly 9 out of 10 times. (See: Fixed Mortgages: 10 Year vs. 5 Year)

Today, however, 10-year rates have nosedived and lenders are stubbornly refusing to pass along lower costs on 5-year terms. So it’s worth a look to see if the tables have turned.

To do this, we ran a little simulation with these parameters:

  • A starting 5-year fixed rate of 3.19%
  • A 4.39% 10-year fixed rate
  • Equal payments in the first five years (i.e.  the monthly payment is topped up on the 5-year fixed to match the 10-year fixed payments)
  • A 25-year amortization

The result is that 5-year rates would have to jump roughly 3% in 56 months for a 10-year fixed to cost less. (We say “56” months instead of five years because borrowers can hold renewal rates at least four months prior to maturity.)

To put a 3% rate increase in perspective:

  • The last time rates leaped that high was 17 years ago in 1994
  • It would imply 5-year bond yield of roughly 4.25%, assuming mortgage spreads stay the same (which they won’t, but it’s a fair guess anyway). A 4.25% 5-year yield is well above the long-term (2001-2011) average of 3.43%.
  • With the BoC’s modest 2% inflation target and lackluster economic growth forecasts, many would argue that an up-move over 3% is fairly unlikely in 56 months (but not certainly not impossible).

Now, this is not to say 10-year terms are pointless. They have their applications. Two examples might be the homeowner with extreme risk aversion or the landlord who wants to lock in a cash flow spread for the long-term.

Either way, you’ll pay a hefty cost up front to know your rate for years 6-10 in advance. Other things being equal, taking a 10-year term will guarantee that you pay roughly $6,000 more interest than the 5-year fixed. That’s in the first five years alone, and it’s $6,000 more for every $100,000 you borrow.

Of course, if rates stay low for the next five years, you can always break your 10-year term after 60 months. In that case, you’d generally pay a 3-month interest penalty, assuming there were a cheaper mortgage to switch into. When feasible, doing this does reduce the downside of a 10-year term, but you’ll still be out $6,000/$100k of mortgage, plus the penalty.

All told, recent rate cuts have made 10-year terms less bad, but they’re not tantalizing yet. They’d probably have to crack the psychologically important 4.00% barrier before homeowners start biting in significant numbers.

Rob McLister, CMT