published by The Globe and Mail on July 22, 2013
by Robert McLister
The trick to making a mortgage disappear faster is to minimize your total borrowing cost. And nothing dictates total borrowing cost more than the term you chose.
Picking the right term is even more important than selecting the best lender, choosing the appropriate mortgage features and finding the lowest rate. Choosing the wrong term can lock you into a punitive rate for years to come or, conversely, expose you to rising rates because you haven’t locked in for long enough.
“Term” refers to the length of a mortgage contract. The most common option is the five-year fixed term, chosen by well over half of Canadian borrowers.
But popularity doesn’t make a mortgage right for you. The ideal term will vary as interest rates and your financial circumstances change.
In the last two months, longer-term fixed rates have jumped by up to half a percentage point. That’s made certain terms less appetizing than others. These are some of the best and worst terms du jour – the stars and the dogs of today’s mortgage market.
Four-year fixed rates are still less than 3 per cent, and will save you about one-third of a percentage point versus the interest rate on a five-year fixed term. Multiply that by four years and you’re talking about potential savings of more than a couple thousand dollars of interest on a $200,000 mortgage.
To be sure, a five-year fixed term may shield you from rate hikes for one extra year, but it also boosts your chances of paying a penalty if you break or renegotiate your mortgage early.
If you instead take a four-year term and renew into a one-year term, you’ve covered the same five-year timespan and given yourself more flexibility in the process. Bump up the payment on your four-year mortgage to match a higher five-year payment and you’ll whittle down your mortgage even quicker.
One-year fixed mortgages are low-margin products that most lenders don’t push, but they can be an attractive product for the right borrower. For starters, one-year fixed mortgages come with rock-bottom interest rates, roughly 2.39 per cent as we speak.
That’s a good solution for well-qualified borrowers with less than 15 years remaining on their mortgage – who don’t mind taking a gamble that interest rates will stay low for longer.
One-year terms are also an ideal substitute for a variable rate. The rates on a one-year term are lower up front and you can renew into a variable rate mortgage in 2014, a time when many expect variable-rate discounts to improve. If you would rather lock into a fixed rate at renewal, you can secure that rate ahead of time – typically six to nine months after starting your one-year mortgage.
You’ll save 0.40 percentage points by choosing a variable rate mortgage instead of a four-year fixed term. But you give up all rate protection, which could come in handy by 2015. Moreover, the 0.5 percentage point discounts on the prime rate (that today’s variable mortgages offer) could improve by next year with a drop in lenders’ cost of funding these mortgages.
Unless there’s a good chance you’ll break your mortgage in three years, look elsewhere. The 0.10 percentage points you’ll save off a four-year fixed term could easily be offset by higher rates when you renew.
Mathematically, seven-year terms are a bad idea and almost always have been.
The few extra years of certainty simply don’t justify the rate premium you’ll pay over a four- or five-year fixed rate.
If you’re that worried about inflation driving up interest rates, shell out another tenth of a percentage point and get a 10-year term.
THE IDEAL MORTGAGE
Calling one mortgage term the “best” is like declaring the best flavour of ice cream. The ideal mortgage is different things to different people.
Picking the right term rests on your individual circumstances and will depend upon the risks that you may face. If there’s a significant possibility that your cash flow may dip in a few years, or that you won’t be able to prove your income or credit worthiness at renewal, then a one– or four-year mortgage may not be worth it.
Instead, the extra up-front cost of a 10-year fixed might actually be justified.
Moreover, if your debt levels are above-average, you might not even qualify for a variable-rate or a one- to four-year fixed term. (Lenders’ affordability standards are stricter on those terms.) If that’s the case, you may be forced into a five- or 10-year fixed term. There’s no question that more folks will wind up in this boat as rates climb and qualifying becomes tougher.
All that said, spend as much time on picking a term as you do on picking a rate. Your investment in time will pay dividends through lower borrowing costs.