The overwhelming majority of today’s mortgagors are picking fixed rates.
More than ever, these folks are torn between a 5- or 10-year fixed term (“nickel” or “dime” in our slanguage).
To get an outside perspective on this decision, we turned to York University Professor Moshe Milevsky, someone in whom we have a great deal of trust when it comes to mortgage term analysis.
The following scenario was posed to him:
Our imaginary borrower can choose between a 5-year fixed at 3.14% or a 10-year fixed at 3.84%
The borrower must make equal payments for the entire 10-year term—for an apples-to-apples comparison (i.e., the homeowner would pay his/her 5-year fixed like it was a 10-year fixed.)
The amortization would be set to 25 years
Moshe says the “critical question” is, “How much would the new 5-year fixed mortgage rate have to increase (at renewal) before (the 5-year borrower) would have to make payments higher than the (10-year borrower)?”
Mathematically, he says, that rate would need to rise past 4.32%. (For simplicity, his break-even calculations use monthly compounding instead of semi-annual, but they’re a good approximation.)
“This is an increase of 118 basis points relative to the current 5-year rate,” he says.
“If I had to guess, I would place greater than 50% odds of this event occurring. In other words, it is more likely than not. It has happened in the past.”
Amortization turns out to be key in this discussion. “If (the 5- and 10-year borrowers) were both amortizing their…mortgage over a shorter 10-year period, the results would be quite different.”
At a 10-year sample amortization, he says “The break-even number is higher…The spread in that case is 302 basis points.”
“This (a 302 bps rate increase) is an economic event that is less likely to occur – although definitely a possibility. You can’t ignore this risk, but it is much smaller than the risk (of a 118 bps rate increase).”
Total Borrowing Cost
Moshe’s analysis is essential for those considering payment risk. He acknowledges, however, that “total borrowing cost” is a different matter.
If you look at it from a total interest basis, the break-even renewal rate after the first five years is higher. Ron Cirotto, from amortization.com, ran a simulation for us (pictured below) that factors in total interest paid over 10 years.
Ron notes: “The second 5-year term rate would have to be approximately 4.85% to make the two (consecutive) 5-year terms add up to the same interest paid as the 10-year rate.”
Ron’s calculations match our own findings.
So, on a total interest cost basis, the “break-even” point is roughly 171 bps above today’s typical 3.14% five-year rate. If one can snag a five-year rate closer to 3%, the break-even point shifts further in the five-year borrower’s favour.
Note that these results don’t take into account the time value of money. Technically, this is an important point, but as Ron mentions: “Using the rule of 72, it takes approximately 35 years at 2% inflation to have your money worth half as much.” So, time value of money “is not really a significant factor in the analysis.”
Moreover, the payments (cash flows) are assumed to be the same for the entire ten years. Therefore, if the 5-year payment exceeded the 10-year payment in years 6-10, we assume the 10-year borrower would increase his/her payments to match the 5-year term. Again, this keeps things apples-to-apples when we compare total interest expense.
Amortization & Overall Risk
If total borrowing cost matters more to someone than the risk of higher payments in years 6-10, that would likely increase the appeal of the 5-year term. But there are other considerations.
Here are some tips and takeaways that Moshe provided us with:
“The longer the amortization of your mortgage and the time period over which you plan to make mortgage payments, the more attractive the 10-year fixed rate mortgage looks, relative to the 5-year fixed.”
“If you want to go with the 10-year (amortization), try your best—scrimp and save—to shorten the amortization period.”
“Most importantly, I believe that Canadians should first and foremost take a comprehensive approach to what I like to call “debt allocation”. The type of debt you take, its maturity, quantity and flexibility should be determined in conjunction with the rest of your personal balance sheet. Period.”
On that last point, Moshe advises borrowers to “Think of your other assets.” That’s a consideration that he says is “completely ignored” by most mortgage advisers.
“If you have a substantial amount invested in fixed income (bonds), for example, then you are facing Mark Carney’s double jeopardy,” he says. “When short- and long-term interest rates eventually go back to normal levels, your retirement bonds and bond funds will take a big hit. The last thing you want is to have to renew your mortgage around the same time.” (“Conversely, he says, if one’s investments are mostly stocks and few bonds, the suitability of the 5-year fixed mortgage would increase.”)
“Moreover, if real estate prices have since declined (by renewal time), and you are teetering dangerously close to negative home equity, your entire personal balance sheet will be at risk.”
Yet More Considerations
The above underscores how one cannot compare 5- and 10-year mortgages by interest cost alone. There’s much more to consider.
For example, 10-year terms are often criticized because of people’s tendency to discharge their mortgage early. However, broker and industry trainer Greg Williamson says, “In today’s low rate environment, and what might be a rising rate environment over the term, breaking one’s mortgage is less likely.” He says people may be increasingly prone to keeping their good 10-year rates.
One way they could do that is by porting their mortgage to a new property (or porting and increasing with a blended interest rate).
But, homeowners might regret a 10-year term in cases where they:
Need more funds and their 10-year lender won’t approve them for what they need
Need to sell without porting (for any reason, including financial issues, desire to cash out and rent, downsizing, job loss, divorce, etc.)
Need to extend their amortization or refinance to lower payments
Want to switch into an unexpectedly low 5-year rate (if such low rates exist going forward)
Need to blend their interest rate, but their 10-year lender won’t offer a decent rate or terms.
If any of these things happen while you’re in the first half of a 10-year term, the penalty to break your mortgage might be stiff.
If, however, they happen in the 2nd half of a 10-year fixed, you can “escape” the mortgage with just a 3-month interest penalty (thanks to provisions in the Interest Act). That’s a key point in the 10-year’s favour. It’s kind of like having an option contract.
By contrast, terminating a 5-year mortgage early would potentially expose you to an unpleasant IRD penalty.
A 10-year term is “especially (attractive) for the self-employed who don’t know if qualifying may be more difficult in future,” says Barb Morgan, Director Business Development at Concierge Mortgage Group.
“On a 10-year, 3.89% (or less) is a lot of security for a long time. Many people are coming out of 5-year terms with (notably) higher interest rates.”
Greg agrees. “It’s hard to sell a strategy that hedges against every unforeseen thing,” he says, “but I currently love the low risk of a 10-year at today’s rates, versus two 5-year terms at what might be normalized rates.”
History & Future
“In these extraordinary economic times, I believe that history is less relevant for the purpose of forecasting or projecting future interest rates,” says Moshe. “Indeed, the volatility of short-term rates in the last few years has been close to zero. But it would be ridiculous to extrapolate that volatility is dead.”
“If anything, the risk of a ‘pop’ in rates is ever growing. A mere 118 basis points is nothing. It can happen over a bad weekend.”
The upfront 70 basis point rate premium of 10-year mortgages, “is the price of safety…The value of safety depends on whether you need it. I don’t own a boat, so I don’t need boat insurance. It might be very valuable to you, if you have a yacht moored at the local marina.”
In this case, that 10-year “insurance” is guaranteed to cost at least $3,300 more than a 5-year term over the first 60 months, per $100,000 of mortgage.
Nine out of ten times historically (see: Fixed Mortgages: 10 Year vs. 5 Year), the “safety” of a 10-year term has cost you more in interest than two consecutive 5-year terms. But there’s that 10% of the time you just can’t ignore. Historical performance is especially debatable given today’s misleadingly low stimulus rates, and the chance that an economic recovery could eventually push inflation (and rates) higher.
Moshe reminds us in closing, however, that proper mortgage financing “should always be first and foremost about proper risk management” and not about “trying to second guess the billion dollar bond market.”
Rob McLister, CMT
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