Interest rates have nowhere to go but up. No doubt you’ve heard this line if you’ve bought a home or had to renew your mortgage at some point in the past decade, followed by an eager banker or mortgage broker urging you to “lock in” now.
Most homeowners in Canada prefer fixed-rate terms for predictability and peace of mind, with five-year terms being the most popular.
Yet despite its popularity, the five-year fixed rate is likely the least advantageous term for borrowers.
Going Long: 10-Year Mortgage Term
For those looking for greater protection against (eventual) rising interest rates, a longer term is worth a look. A 10-year fixed rate mortgage today can be had for as low as 3.69 per cent.
Another reason to consider a longer mortgage term: a safeguard against the possibility of a housing crash. What happens if prices fall 20 per cent or more in the next few years, wiping away your home equity before it’s time to renew? A 10-year term, while more expensive than a shorter term, does offer a double-dose of protection in case prices fall or interest rates rise substantially.
Certified Financial Planner Ed Rempel doesn’t buy the safety argument, saying that the risk of rising interest rates is ‘hugely exaggerated’ in the media and by the mortgage industry.
“Long mortgage terms are marketed as “insurance” to protect against a possible rise in interest rates. But most people are not good at math and don’t take into account the extremely low odds of a large rise, plus the huge cost of the insurance,” said Mr. Rempel.
A five-year fixed rate mortgage costs around 2.64 per cent today while a two-year fixed comes in at 2.29 per cent. Mr. Rempel says the difference doesn’t sound like much, but on a $300,000 mortgage this 0.35 per cent premium costs $2,100 after tax for the first two years.
“This is expensive insurance to protect against a highly unlikely event,” said Mr. Rempel.
Stop Short with a 1-or-2-Year Fixed Rate Term:
If long-term mortgages offer peace of mind (for a premium), a short-term mortgage – such as a one-or-two-year term – gives homeowners the opportunity to save money in exchange for a bit of uncertainty when it comes to future interest rates.
With a one-year term, for example, homeowners get more flexibility because they can renew their mortgage in 12 months instead of in three-to-five years. At that time they can renew into another one-year term, lock-in to a longer-term fixed rate term, or take a variable rate at presumably a better discount than today.
Those who opt for a one-year fixed rate can also lock-in their renewal rate in just six to nine months – they don’t have to wait a full year.
So why don’t more homeowners choose a one-year term? According to data from Mortgage Professionals Canada, just one in 16 borrowers take a one-year fixed rate mortgage.
Mr. Rempel says that’s because people don’t want the headache of renegotiating every 12 months. But it’s a mistake to give up that negotiating power.
“From a financial planning perspective, I find that most people can benefit from some type of refinancing every two years,” he said.
The bottom line
Homeowners looking to save the most money year-over-year should consider a short fixed term of one-or-two years, while those looking for maximum peace of mind can find comfort in a 10-year mortgage term at rates under 4 per cent.
In addition to running the Boomer & Echo website, Robb Engen is a fee-only financial planner. This article originally ran on his site on April 27th and is republished here with his permission.
I suspect Mr. Rempel was living at home with his parents in 1982 oblivious to the 21% interest rate their neighbour was paying after experiencing an all but overnight doubling of rates. No, not 21%, but more than a doubling of current rates is conceivable. That impact will be even more significant today given the stretched financial condition many Canadian homeowners are experiencing.
Also, the spending-saving habits of Canadians are significantly different today than in the 1980s. To suggest that the “$2100” would be saved is indeed an opportunity, but certainly not a reality or likely.
Risking one’s shelter is not prudent and certainly not advice I promote to my children who are busy beating down huge mortgages. Mr. Rempel’s calculations are likely accurate, but his advice is certainly questionable.