No one truly knows where interest rates are headed. Yet, despite vast margins of error, all major financial institutions regularly publish rate predictions.
If only we could assume that these economists were right – or even half right – it would be far easier to determine the lowest-cost mortgage term.
That’s not possible of course, but what if we pretended for a minute that today’s long-term rate forecasts were indeed accurate? With this hypothetical, we’ll estimate which mortgage term offers the best value and see if any conclusions can be drawn.
It’s first worth noting that few reputable sources publish rate forecasts beyond two years. TD Bank and Desjardins are two FIs that do. Below is a chart showing mortgage rates for the next four years, based on an average of their forecasts.¹
(Click to enlarge)
If rates evolved as you see in the above chart (i.e., if TD’s and Desjardins’ consensus forecasts turn out to be right), today’s 2.99% five-year fixed would easily outperform a 5-year variable. Its projected savings versus a variable would be more than $8,000 over 60 months on a $250,000 mortgage.²
In fact, a 2.99% five-year would beat virtually every other mortgage term based on interest cost to maturity. (The one possible exception would be a 10-year fixed but its performance would depend heavily on rates in years six through ten.)
Unfortunately, actual rates always vary from economist projections, so one hypothetical alone provides only limited value. We typically do a series of them when advising clients and couple that with stress-testing (i.e., determining the rate exposure someone can withstand at renewal) and evaluating the applicant’s goals and finances.
Interestingly, research confirms that economists habitually overestimate future rates when current rates are below average—as they are today. Given that, let’s run a second simulation and see how mortgagors would fare if TD and Desjardins were only half right (i.e., if rates rose by only half of the amount they predict). The graph below illustrates this scenario.
(Click to enlarge)
In this sample case, where rates rise more gradually, a 2.99% 5-year fixed still beats a prime – 0.40% variable. The best hypothetical value of all, however, is the 1-year fixed—if you can find one near 2.39%.
Given the above rate scenario, a 1-year fixed strategy entails a $2,700 savings versus a 5-year fixed in our simulations. That’s measured over 60 months and assumes you renew into successive 1-year terms.
The 1-year fixed turns out to be a reasonable play for well-qualified borrowers who can handle the renewal risk and have sufficient savings or equity and/or a shorter-than-average amortization.
Given future uncertainty, however, the 2.99% five-year fixed remains a tremendous value. It performs well in most rate increase scenarios and is particularly appropriate for conservative borrowers who don’t need to break their mortgage for five years (which would entail penalties).
If you assume a higher probability of rate increases than rate decreases, the cost of picking the wrong term is lower in a 2.99% five-year fixed than in a short term or variable rate. That has seldom been the case historically. In today’s market, that makes the venerable 5-year fixed the best value for most borrowers.
Note: There are numerous other factors that guide term selection. As always, consult a mortgage professional for a recommendation specific to your circumstances.
¹ Desjardins’ forecasts are based on annual average rates. We’ve extrapolated those rates into year-end forecasts. That helps us average them with TD’s numbers. The 5-year fixed rate in the charts is based on a 150 basis point spread above the government of Canada 5-year bond. The 5-year variable is based on prime rate, less a 40 basis point discount. Since TD and Desjardins don’t forecast past 2016, our hypothetical term comparisons assumes that rates plateau in 2017.
² Assumes a 25-year amortization with no mortgage changes required before maturity.
Rob McLister, CMT