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The Unsung One-Year Mortgage

rates-mortgagesPeople haven’t been lining up for short-term mortgages, given the mesmerizingly low rates on 5- and 10-year terms.

But if you’re a financially secure borrower and you believe that rate direction is random (it is), then 1-year rates shouldn’t be written off. That was my topic in this week’s G&M column.

By way of example, suppose you need to borrow for at least five years. If you’re not risk averse, you might consider options like a:

  • 5-year fixed
  • 1-year fixed …which lets you renew into a 4-year fixed at maturity (or any term for that matter)
  • 5-year variable …at a rate that’s ~20 basis points higher than a 1-year fixed

The total borrowing timeframe is the same in each case, five years. But the 1-year mortgage gives you an option to:

(a)  capture the maximum upfront interest savings and then keep enjoying low rates if borrowing costs stay low, or

(b)  switch to a longer term after 12 months if rising rates start stressing you out.

When to lock in is always the hard part. Most folks who try to time the market find it to be a losing proposition.

But some people take the guesswork out of it by using pre-set rate levels to determine when to convert. For instance, they might ask their mortgage planner to lock them in if the lowest 4-year fixed rate has risen above 3.25% (an arbitrary example).

This approach is similar in principal to a stop-loss order in trading.

A “stop-loss” gets you out of a trade at a pre-set loss. That lets you determine your risk in advance and prevent emotional and costly market timing.Mortgage-Stop-Loss

The challenge with most 1-year terms, compared to variable rates, is that you usually have to wait until three to six months before maturity to secure (hold) your renewal rate. By contrast, most variable-rate mortgages let you lock in at any time. That makes them preferable to 1-years in certain situations.

Other variable and 1-year differences:

  • A variable rate drops when prime rate drops.
  • A 1-year mortgage fluctuates less, potentially letting you hold low rates for longer than a variable.
  • A 1-year is currently cheaper up front (because the rate is lower than a variable).
  • A 1-year lets you switch terms at maturity at the best available rates. (You’ll rarely get the best rates when converting a variable mortgage to a fixed rate during your term.)

One unique case is the 1-year “convertible” mortgage. It lets you lock into a longer fixed mortgage at any time. In other words, you don’t have to wait until six to nine months into your 1-year term. Convertibles are harder to find but quite flexible if you can locate one that’s cheaper than a variable rate.

All-in-all, are 1-year terms right for most people? The answer is no. But they’re definitely right for more people than the 6% of borrowers who actually choose them.

More: Globe Story

The usual disclaimer: Exceptions apply when it comes to term selection. Please seek personalized advice.

Rob McLister, CMT