…and why they may not be the best choice for your mortgage.
There has been a lot of talk in the news the last 2 weeks about extended fixed terms, namely 7 and 10 year fixed mortgages. It’s true that rates are historically at their lowest right now and a 10 year mortgage at let’s say 5.25% looks very appealing but there are many things to consider before committing to such a long term.
First off, let’s get real…essentially you are paying a premium for safety when you consider that a 5 year fixed rate mortgage is at 3.79%, the difference is pure interest costs which is 1.46% additional interest. In the end you may be paying more interest than going with a lower term at a lower mortgage rate.
For example let’s compare a $250,000 mortgage with a 25 year amortization for both a 5 year fixed at 3.79% and a 10 year fixed at 5.25%. Also, we will assume that rates would go up to 6.29% for a 5 year fixed after the first initial 5 year term. Again, that increase is an assumption – no crystal ball here.
On the 10 year mortgage your monthly principal and interest payment would be $1,489.80 as opposed to the 5 year term at $1,286.75. This is a huge monthly difference of $203.05 which is again, pure interest costs to you the client (as the banks are wringing their hands with big grins). Over the course of a 5 year term the difference is $12,183, quite substantial.
Now let’s say for the 5 year term scenario that when your mortgage comes up for renewal you have choices between a variable or a fixed again. Variable rates are typically lower than fixed but also have a different degree of risk associated with them. In this case we will say that rates rose by 2.5% to a 6.29% 5 year fixed rate in 2015 and you renew at that rate and term. Your payment jumps up but overall based on this scenario your total payments going 5 years and 5 years would be $175,776.60 as opposed to the 10 year fixed term which would be $178,680. A difference of $2,903.40 which shows that the 5 & 5 (in this example) may benefit you more.
Now you may say, well it is only $2,903.40 in savings when we can be guaranteed the 5.25% for 10 years. That can be true but don’t get caught up in the savings in interest alone or the rate on the 10 year fixed term. In Canada, when you break a fixed rate mortgage prior to maturity there is usually a penalty attached to this action. It is called an IRD, interest rate differential and is calculated by taking the outstanding mortgage x difference in interest rates at the time of breaking to what you have x time left to maturity. You are allowed to get out of your mortgage on the 10 year fixed after 5 years without an IRD but this still may be a high amount of interest to have paid over the 5 years. I have seen many clients pay out a penalty last year and this year to refinance into the rock bottom rates, but only if it made sense in the end and only if they could recapture the penalty quickly with the new mortgage. Clear as mud?
Also, from my experience – life happens. You may think you will stay in a home forever but; families grow and need larger homes, refinancing for renovations or debt consolidations may be required, the need to pull out equity from the home may come up for other reasons, not to be morbid but sickness can enter the lives of loved ones and financial situations may change, and marriages and partnerships may dissolve. All of these life situations contribute to breaking a mortgage and paying a penalty. This is part of the decision process when you commit to a 7 or 10 year mortgage, not just rate as it may come back to bite you later on with an unaffordable penalty.
Studies have shown (I’ve always wanted to write that), that most Canadian consumers break their mortgages every 36-38 months into a 5 year term. Just another tidbit of info to consider.
Any questions? Please feel free to contact me directly, I am here to help. You are always best served by a Mortgage Broker who understands the benefits and downsides of all terms, options, and rates available in the Canadian mortgage market.
Kim Gibbons
Your “Mortgage Superhero ®”
Toronto 416-400-8107
