Pros And Cons Of Going Short With Your Mortgage
Fixed or variable? Long or short? Whether you’re a buying your first home or renewing your mortgage, finding the right mortgage term can be a difficult decision.
The majority of homeowners opt for a five-year fixed term as protection against future interest rate hikes. However, you’ll pay a premium for that peace of mind, both in terms of higher rates and stiffer penalties to break your mortgage.
Related: Waiting To Buy A Home – Pros And Cons
If you’re looking to save money on your mortgage, nine times out of 10 you’re better off with a variable rate. Going variable used to get you big discounts, as much as prime minus 0.80%.
But times have changed, and those discounts have all but disappeared. Robert McLister, editor of Canadian Mortgage Trends, says one-year fixed rates are now below floating rates.
Whereas the best variable rate is currently 2.65%, a one-year fixed term can be had for 2.39% or better.
“That makes them a solid variable rate substitute, especially since one-year rates move with variable rates 93% of the time,” says McLister.
Advantages of a One-Year Fixed Term
At today’s rates, you’ll save nearly $700 per $100,000 of mortgage in the first year with a one-year fixed term versus a five-year fixed term.
So, if you’re looking for a mortgage today, a one-year fixed term might be right for you. Here’s why:
You’ll get more flexibility because you renew your mortgage in 12 months instead of in three to five years.
At that time you can renew into another one-year term, lock-in to a longer-term fixed or take a variable at presumably a better discount than today.
Related: Shopping For Mortgage Rates – Fixed Or Variable?
In a rising interest rate environment, the rate on a one-year mortgage increases slower than a variable rate.
You can lock-in your renewal rate in just six to nine months – you don’t have to wait a year.
One-year fixed terms are also smart for people with short amortizations. That’s because potential rate increases at renewal won’t affect you as much since your payments are mostly principal.
Disadvantages of a One-Year Fixed Term
So why don’t more homeowners choose a one-year term? According to the Canadian Association of Accredited Mortgage Professionals, just one in 16 borrowers take a one-year fixed.
That’s partly because people don’t want the headache of renegotiating every 12 months and partly because variable rates have typically been better.
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There are other disadvantages to going short with your mortgage.
Lenders usually pay your switching costs when you choose a longer term mortgage (three to 10 years).
By contrast, when you move to another lender and select a one or two-year term, lenders often won’t pay your switching costs.
A one-year term can leave you exposed if rates jump, so you’ll need to be well-qualified and open to risk, or have only short-term financing needs.
Well qualified means having good credit, reasonable debt ratios, provable stable income and ample emergency savings or equity.
Related: How Much House Can I Afford?
It’s harder to qualify for a one-year fixed term. With a five-year fixed, you’ll have to prove you can make payments at today’s rates (2.99% – 3.09%).
But if you’re getting a one-year fixed term, most lenders want to ensure you can afford the five-year posted rate – which is currently 5.24%.
That rules out many first time home buyers, who generally have much less equity, net worth, job stability and ability to withstand 20 to 30% payment increases. They’re usually better suited to longer terms.
Fortunately, the rate differential between long and short terms is exceptionally reasonable today. For just 0.6% more than a one-year fixed, homeowners can guard against interest rate hikes for five full years.
Final Thoughts
McLister points out that anyone choosing a one-year fixed term should consider setting their payments based on a rate that’s 2% higher.
“That way you’ll have minimal payment shock if and when rates climb. You’ll also chip away big chunks of principal,” says McLister.
That’s exactly what we did when we bought our house last summer. We went variable, since the discount was prime minus 0.8%, but we set our payments based on a 5% rate.
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The economic outlook remains bleak, so interest rates won’t likely be rising any time soon.
Variable rate aficionados should consider a one-year fixed term; at least as a temporary measure, until we see those big discounts on variable rates come back.
We purchased a house a year and a half ago and since the mortgage was higher then normal, we decided to go with a fixed rate and 5 years of sleeping like a baby.
Not the most efficient way to mortgage a house, but since we throw down extra money each month, it will be a much easier number to handle when we renew in 3.5 years. Then I will feel much more comfortable with a variable rate mortgage.
But who knows what the rules will be with mortgages in the future. Best to play it safe when it comes to your most important investment.
@The Loonie Bin – A lot of people prefer the 5-year fixed for their first term. I sleep better at night knowing I’m paying less interest 🙂
People worry about their payments going up when interest rates rise if they have a variable rate, but your payments won’t change unless you reach the ‘trigger rate’, which is quite a bit higher.
There are always so many options it seems when buying a home. If you’re not careful you can easily be lead astray by how great a deal can sound. I know we thought a lot about variable vs. fixed, length of loan terms, and how much we could actually afford each month. We finally went with a 30 yr variable loan. We have however been making payments like it was a 15 yr loan. Even though we could have gotten a bigger loan and a bigger house stretching to the end of our budget with the 30 yr loan, we wanted some wiggle room in case of an emergency. This way we can lower our payment for a few months if necessary. Right now, I hope we can just pay it off sooner and not have to pay the extra interest.
I’d like to comment that Canada’s mortgage term and interest rate structures are pathetic compared to the US. In America, it’s possible to get a 30 year mortgage, and rates are quite simply stupid-low (as are housing prices). Plus the interest can be deducted anyway.
Canadians have gladly locked themselves into obscenely high rates given the current BoC rate, and they only get the benefit of a five or ten year term. The banks rightfully laugh at our stupidity.
Sure, in Canada, the capital gains are tax-free; but after our gigantic bubble pops, are the Boomers really expecting they’ll cash out a giant pile of equity? It’s gonna be a blood bath. Everything else about housing in Canada sucks, and it’s all about to get a lot worse. I agree that rates probably won’t go up for a while; especially since our ridiculously bloated housing sector is already collapsing without any rate hikes.
@Joe – Sure there are benefits to a 30-year mortgage in a low rate environment, but from what I hear, refinancing can be a challenge. I’m happy with 2.2% for the next few years 🙂
I’ve also heard there’s a housing market outside of Toronto and Vancouver.
I’m a mortgage agent myself, and I can tell you folks reading this article, that this is excellent information. It’s true, very few people take a one year rate, but that does not mean they are wrong.
For most of my career, I was a five year fixed rate zealot, and I admit to you now, it was a costly mistake dispensing that advice in many cases.
Lenders and mortgage agents will not often guide you in the direction of a one year term (if your application is very strong)
One reason is everyone makes more money (and less risk of losing the client relationship) if you commit to a longer term.
But fwiw, we just renewed our mortgage last month – taking a one year rate on the balance, and an available home equity line of credit for investment purposes on top.
@Ross – thanks for stopping by and sharing your experience. It’s true, the five-year fixed seems to get pushed most often.
I’m now a believer in taking the 5-year variable or the 1-year fixed, depending on the discounts available at the time.
“If you’re looking to save money on your mortgage, nine times out of 10 you’re better off with a variable rate. Going variable used to get you big discounts, as much as prime minus 0.80%.”
The key word being “used to.” Canada will most likely be in a rising interest rate environment for the first time in many years. Who’s to say where interest rates will be in 5 years time? I don’t see how they can go any lower. I don’t think you can simply say fixed is always better than variable or vice-versa – it all depends on the moment in time. I would have been happy if I got a Variable Prime minus 0.90% mortgage with RBC last year. It would have saved me a lot of interest in the short-term, but I’m happy with my 5 year mortgage at 3.04%.
@Sean – We’ve been in a so-called rising rate environment for 4 years now, and all we’ve seen is a 0.75% increase in that time.
I’m not suggesting a 5-year fixed today is a bad move (3.04% is a great rate). What I am saying is that when there’s a big discount on variable, that’s been the smart move…and when those discounts dry up, the 1-year fixed is worth a look.
“I don’t think you can simply say fixed is always better than variable or vice-versa – it all depends on the moment in time.”
According to the Moshe Milevsky study, based on data from 1950 to 2007, the average Canadian could expect to save interest 90.1% of the time by choosing a variable-rate mortgage instead of a fixed.
http://www.advisor.ca/images/other/ae/ae_0208_mortgages.pdf
That’s some pretty convincing evidence that variable is better. Could this currently be the 1/10 time that fixed rates are a better deal? Maybe, but I put my money on variable.
I’m a mortgage broker as well, and I find the one-year fixed term good for certain clients, especially those that won’t be exposed to risk should there be a slight shift in the market. As for trading in a housing market that completely collapsed on itself for a 30 yr mortgage….I’d still rather take what we’re getting – which are still pretty low.
Taking a 5 year term isn’t just about sleeping like a baby at night. It can be about keeping your house.
If we wake up one day and interest rates are at 18%, lots of people with short term or variable mortgages are going to lose their houses.
And the reason people don’t worry about that is because they don’t remember when interest rates were 18% and people lost their houses. But it happened back in the 80’s, ask your parents. And it can happen again.
Just like people didn’t inherently believe we could have a market crash as bad as we did a number of years ago.
And the proof of this is in the U.S. housing market meltdown – with a lot of people losing their houses. There was a lot of nonsense going on, but part of it was balloon mortgages where the mortgage renewed at a higher interest rate that was unaffordable. Boom, you lose the house or go bankrupt. Or both.
Which is why I’ve always taken long mortgages. It gives me the certainty that no matter what happens during that term, we can’t wake up one day and not be able to afford to live in our house.
@Glenn – Comparing our 5-year variable rates with the teaser rates offered in the U.S. to sub-prime borrowers is a bit of a stretch.
I’m not sure how a 5-year fixed protects you from losing your house. If you had a 5-year fixed in 1977 at 10%, you were renewing at 18-20% in 1982.
Besides, Milevsky’s study covers a 50 year period, including the early 80’s when rates went up like crazy, and variable still came out ahead.
This is about paying less interest over time, and if you want to build a cushion in case rates rise then you simply fix your payments at a higher rate.
@Glenn- I used to regularly direct people into a fixed 5 year term mortgage – especially first time home owners. Also, some people just don’t want to take on the risk of variable rates and shorter terms.
The pitch is that they will have the security of knowing exactly what their payment will be for an extended time. The truth is that financial institutions make more money on longer terms with the security of knowing their customer will be with them for the term and not looking elsewhere.
In the early 1980’s I had the thankless job of working with the many foreclosures that occurred at that time when the higher interest rates increased mortgage payments substantially and couldn’t be paid. Couple that with the loss of employment and it was a disaster.
It is a lot easier to work your budget to manage small increases – such as with groceries – than to have a sudden huge increase at a later time.