Everyone seems to be taking a 5 year fixed rate, should you as well?
You are about to make an offer on a home and you now have to decide on the dreaded question, “what type of mortgage product should I take?” It is an important question and can be a bit complicated weighing the pros and cons, and trying to ignore all the outside advice from family, friends, media, and now me!
Here is some basic philosophies, numbers and thoughts to help you make your decision…well, at least I hope it helps! I will start with basic information and then dive into some more complicated scenarios and ideas towards the end. This post will be a bit long but it will be worth it if this is your question.
They are the safest of all the mortgage products out there because you are not exposed to market changes (up or down). You now know for the entire term (1-10 years fixed) that your rate and payment will not change. This provides comfort and safety, and also is a huge help with budgeting.
Fixed rates are also really helpful when having rental properties or non-occupied homes such as vacation homes. You do not want to have those types of properties having significant fluctuations because your budget is usually tighter for those properties and if its a rental, your cash flow margin is based off of the current payment.
The key thing to remember, anything safe has a price. You always have to pay for safety. Fixed rates are no different when getting a mortgage. You will be locking in an interest rate and will be significantly higher than the variable rates (currently and historically) and may cost you thousands over the term you sign up for. With that being said, if you see an upward trend of interest rates and economists predicting that rates are increasing indefinitely, then locking in while they are low could save you money. It is a difficult dance between taking a fixed rate and a variable rate because no one has the crystal ball to predict the future of rates. So, what do you do?! Consider this. The biggest negative with taking a fixed rate is not whether it saved you enough interest when compared to the variable… the biggest negative is the penalty. Predicting the right length of time to take the fixed rate is the real risk when locking in your interest rate. Year after year Canadians pay out their 5 year fixed rate before the 5 years is up and is costing them thousands of dollars. I have seen way to many pay out penalties over $10,000 over the years and this is your worst enemy when taking a fixed rate mortgage. See the example at the end of this post.
Variable rate mortgages can be a tricky thing. They will typically save you money over the long term and have historically proven that for the last 30 years. With that being said, it is a riskier product because you cannot control prime, neither can I, or the bank themselves. The Bank of Canada controls the prime rate and meets throughout the year (https://www.bankofcanada.ca/2017/07/boc-2018-schedule-fad-mpr-releases/) to discuss key interest rate hikes and drops.
Your variable rate fluctuates on prime and you are now directly affected by their moves. This can be devastating for some families if they saw their monthly payment increase by $50/m every year. Therefore, I do not always recommend a 5 year variable rate because it could hurt the family taking the mortgage, and make home ownership a bad taste in their mouth. For the extremely tight budget a fixed rate may be a better choice, OR, choosing a bank that allows a fixed payment variable rate product. They do exist! This means your payment does not change when prime increases or decreases, but remains the same. But something has to “give”, and it will be your amortization that does. You will no longer be on pace to be debt free in 25 years, but longer depending on the rate jump. More of your regular payment is going towards interest rather than principle and that is the key factor to remember when taking this type of variable rate. It is a great option though for someone wanting to drop their monthly payment and/or have security with a riskier mortgage product.
The other negative is you spend all your evenings as a home owner now researching interest rates and the future of rate jumps and what economists, banks, and brokers are saying. If you cannot sleep at night because you have chosen a variable rate, it is also not likely the product for you. Yes, it may save you thousands of dollars over the next 5 years, but if you have rocky marriage, bags under your eyes, and no social life because your time is researching mortgage rates…that costs far more than the lost savings by taking the fixed rate.
Lastly, as mentioned above the biggest win is payout penalty. This is an incredible product for anyone that is on the fence with the home purchase they are about to make. If you know you will be owning the home you are about to purchase for at least a couple years, but beyond that it seems a bit risky because you may get married, or kids are on the way, or you have been feeling the “itch” to try a different career, then a variable rate may be the best thing for you. You get a great low rate, but you could pay out in year number 1, 2, 3, or 4 out of the 5 years you committed for and have the exact same payout penalty. That is pretty cool!
You are probably wondering, why on earth do the majority of Canadians take a 5 year fixed rate?
Lots of reasons, but the main is security. It is a nice safe product for a decent amount of time. It’s not too short and it’s not too long. We now know based on the info above that it is too long, but if you were to be asked how long you think you will live in the home you wouldn’t think it would be less than 5 years! 10 years seems crazy, 2 years is not long enough, but 5 years feels just right. The other reason it is a profitable and safe product for your bank or lender too. As a business, who wouldn’t want to have a guaranteed rate of return on money for 5 years or longer and have a nice big penalty if you try to leave that early? You will see non-stop advertising and rate promotions on 5 year fixed money because of that reality.
With that being said, fixed rates are not evil. If you are a couple, family or individual that knows 100% that you will be owning that house for the full 5 years no matter what and you are looking for safety, then a 5 year fixed is brilliant for you, or maybe a rental property that you do not want a varying mortgage payment on. I would realize that historically the variable rate almost always wins when comparing rates in 5 year chunks, but this doesn’t mean that the 5 year fixed is not a winner right now. Another thing that is great about fixed rates is you can take a shorter term such as a 1,2, 3, or 4 year. If we know that the majority of Canadians pay their mortgage out around year number 4, then a 2 or 3 year fixed rate could be the happy medium for you. No interest rate risk by taking the 5-year variable, and no risk of a crazy penalty with the 5-year fixed rate, yet you have security in payment and rate (but for a shorter period of time). This could be the perfect mix of all the pros and cons mentioned above.
In summary, you can see that avoiding penalties is the name of the game. Choosing product over rate needs to remain number one, and then you need to trust your mortgage broker (hopefully me haha), to ensure that you got the best rate and lender within the ideal mortgage product you have requested. I recently wrote a blog post on this as well, you can check it out by clicking HERE.
To hit this point home further, if you were shopping for a new van to buy because you now are a family of 6. You would not buy the on sale Honda Civic just because they are on special and a smoking good deal. That is great for someone, but as a family of 6 no matter how good the price is on the Civic, it will not meet your needs. Once you know you need a van, you then get the absolute best price possible for a van and ignore all the extra advertising that is coming at you.
As promised, here is a real life 5 year fixed VS 5 year variable competition:
On a $300,000 mortgage, you have the option of taking a Prime-0.75% variable rate or a 3.3% 5 year fixed rate (hypothetical rates). Most banks, clients and brokers will immediately think, “well, I know that rate jumps happen a quarter point at a time (0.25%), which means in 3 rate jumps I will already be at prime. Today prime is 3.45%, so people will then look at the 3.3% fixed rate for 5 years and say, well it simply makes sense to lock in because it will for sure beyond 3.3% in the next 5 years.”
That is person is not wrong and they are likely correct! It probably will increase over the next 5 years, but take a look at this real life breakdown that the majority of Canadians go through.
Fixed 300k Mortgage:
5 year fixed 3.3% over 25 year amortization. Monthly payment is $1,466.32/month and will owe $257,884.54 at the end of the 5 year term. But the individual pays out their mortgage 3.5 years into the mortgage, which means that at the time of payout the principle balance owing was $271,250.43. They now have an IRD payout penalty that is based on the 5 year posted rate at the time of committing to the mortgage. This means that the bank offered you a mortgage at 3.3%, but the posted rate at that time was actually 5.34% and they happened to give you a discount. This is mentioned in the paperwork you sign, but you never planned to pay out the mortgage early, so you didn’t really pay attention to it. You will then call to the bank and say, “I have a 3.3% interest rate, and the market rates are now 4.3% for a 5 year fixed. They will compare to the lowest term to what you have right now which is a 4% 1 year term. That means you will be paying the IRD calculation pn the 5.34% vs the 4% market rate. This is what creates the nasty pay out penalty!! The penalty is now, $6200 on your mortgage you are 3.5 years into. You need to sell and payout the mortgage, so you take the hit.
Variable 300k Mortgage:
5 year variable at Prime (3.45%)-0.75% = 2.7% over 25 year amortization. The first 6 months the rates do not change and everything stays status quo. Your payment is $1373.96/m for those first 6 months and has saved you $92.36/month in cash flow savings because the interest rate is so much less ($554.16 over 6 months).
Then the rate jumps up by 0.25%. Your payment goes up to $1411.38/m but you are still happy because your rate is still only 2.95%.
Then after that 6 months expires the rate goes up again another 0.25%. Your payment is now $1,448.66/m and you have a 3.2% interest rate. Luckily you are still saving money at this point but it has only been 18 months now out of the 5 year term you have signed up for with the variable.
6 months later, it makes a huge jump and goes up a whopping 0.5%! It is now 3.7% higher and remains that way for the remaining time before you pay out and sell the home 3.5 years into it. Therefore you had the high rate of 3.7% for a full 2 years. You payment during that time was also higher at $1523.40.
At the end of the 3.5 years you steady increases, you now owe $271,514.77 on your principle balance.
The fixed rate was $271,250.43 and the variable rate was 271,514.77. That means the 5 year fixed rate paid down the mortgage faster by $264. Nothing crazy. You would look at this and say its a win win no matter what product you take… not so fast!
Remember the pay out penalty!?! The 5 year fixed rate now has the IRD penalty of $6,200.
The variable rate payout penalty will only be a 3 months interest penalty of $832.90/m x 3 months = $2,498.70.
Fixed rate payout 271,250.43 + 6,200 penalty = 277,450.43
Variable rate payout 271,514.77 + 2,498.70 penalty = 274,013.47
The total savings by the variable rate is $3,436.96!
That is over 3.5 years, and is despite the interest rate increasing every 6 months for the first 18 months and then increasing again by half of one percent making it a more expensive mortgage than the 3.3% by almost a half percent! Yet due to the payout penalty, the interest rate savings was not enough to beat out the 5 year variable rate. This is very common scenario for most of my clients. Only 29% of my clients over the past 5 years stayed to the end. 71% of my clients either sold and bought, refinanced, did a mid term switch. Life happens and it happens quickly!
Thanks for making it to the end of this! I hope this helps understand rates and real life scenarios that you may go through when choosing your next mortgage. As always, I am happy to assist and be a resource to chat further about this whenever you are ready to “take the plunge”.