Should I go short or long; fixed or variable with my mortgage?

“I wish I had an answer to that, because I’m tired of answering that question.” – Yogi Berra

Number 3 on our list of things on which Canadians waste the most money is 5-year fixed mortgages.

They are marketed as being safe and a good protection against a sharp rise in interest rates. The reality, though, is that they are nearly always a huge waste money, they limit your flexibility and result in losing your negotiating power for 5 long years.

That is why we call it the “5-Year Fixed Mortgage Trap”.

I am not a mortgage broker, but have researched mortgages and always have strong opinions. The most common questions about mortgages are “short vs. long” and “variable vs. fixed”. Which is better? Canadians often debate this, but studies consistently show that short beats long and variable beats long term fixed.

If it is so obvious, then why doesn’t everyone see it? Longer term mortgages are marketed heavily by banks and mortgage brokers that make far more money on them then short term mortgages. Also, most people are bad at math and may get a general feeling of security from a fixed rate, but they do not do the math on how much this protection costs or the odds that they will lose money.

“Unfortunately, most of the existing folklore and advice is rarely subjected to formal statistical analysis and does not address the probability that a given strategy will be successful.” (Moshe Milevsky) The main reasons commonly used for taking 5-year fixed mortgages turn out to essentially be myths:

3 Mortgage myths about 5-year fixed mortgages:

1. They are safer

A study by Moshe Milevsky, finance professor at York University, from 1950-2000 showed that the average Canadian wastes $22,000 after tax (based on a $100,000 mortgage for 15 years) in their life because they got sucked into 5-year fixed mortgages rather than variable.

If your mortgage started at $300,000, then you can expect to waste $66,000. They also took on average 38 months longer to pay off their mortgage. The chance of losing money over 5 years was 89%. A study by Peter Draper (mortgage broker) comparing 5-year vs. 1-year mortgages from 1975-2005 showed that the 1-year mortgage saved money 100% of the time! How can an 89-100% chance of losing thousands of dollars be safer?

2. Rates may go very high like in the 1980s

I was an accountant for a mortgage company in 1982 when mortgage rates peaked at 22.75%. My first mortgage was a 5-year fixed in 1980 at 13.75%. I thought that I had lucked out, since rates jumped to 22.75% and were back to 13.75% by 1985 when it came due. What I didn’t realize was that, even then, I would have saved money by going variable! Based on Peter Draper’s study, I would have lost money for 2 years and saved money for 3 years. So, even with a huge leap of 9% in mortgage rates in the first 2 years of my mortgage, I still lost money with a 5-year fixed rate!

Also, the odds of a huge rate rise are extremely low. We can’t calculate them, since it has only ever happened in the early 1980s, but the odds must be extremely low. Demographers, like Harry Dent, claim it related to Baby Boomers entering the housing market for the first time, which is a phenomenon we don’t expect to be repeated in the next few decades.

3. Your mortgage payments will stay the same

Most variable mortgages also keep your mortgage payment the same during the term. Many people believe that their mortgage payment will fluctuate with a variable mortgage, but this is also a myth.

Top 4 reasons to stick to short or variable mortgages:

1. Save thousands

On average, you should save 22% of the starting amount of your mortgage and pay it off 38 months earlier. (Moshe Milevsky) In the Toronto area, an average mortgage is $2-300,000, which would be savings of $44-66,000 after tax. That is essentially one full year’s earnings, so the average person works one extra full year just to pay the money wasted by taking 5-year fixed mortgages!

2. Low risk

With variable mortgages, the chance of saving money is 89-100%. Yes, the variable is the low risk!

3. Flexibility

Many things can happen in your life in 5 years that may make it advantageous to refinance. You may want to move, roll in other debt to get the lower rate, make extra payments with no limit or change some terms. Our experience with our clients is that most do some sort of refinancing every couple of years, so being locked in for 5 years is a long time.

4. Negotiating power

The mortgage market is very competitive, so every time your mortgage comes due, you have lots of negotiating power. You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service. During the term, you have hardly any power. Remember that when you sign a 5-year mortgage, you sign away your negotiating power for 5 years!

The main reason that 5-year fixed mortgages lose money vs. 1-year is that, in a normal market, they start about 2.5% higher. If you pay 2.5% more in year 1, you need the average for years 2-5 to be more than 3% higher than today’s rate. To be ahead, rates would have to jump by more than 3% and stay there for the next 4 years – a very unlikely scenario.

Conclusions:

  1. Stick to 1-year fixed or variable mortgages. Usually, you should take whichever is lower, but only take variable at a good discount, such as prime -.8-.9%.
  2. Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more, plus you will have lost your flexibility and negotiating power for 5 years. Remember that even when rates leaped 9% in 2 years from 1980-82, short term rates still saved money.
  3. Never take a mortgage term longer than you expect to stay in your current home.

We have been referring people to mortgage providers since the mid-90s and most today have rates below 2%. Most of our clients still have the prime -.85% rate that we had for years before this recent crisis or have our recent 1-year rate of 1.99%.

Today, we are recommending 1-year fixed, not variable. The best variable rates are prime -.4-.6%, but rates are normalizing quickly. We expect that the prime -.85% (or lower) rates will be back soon. We expect that anyone taking a variable today will regret having locked in before the larger discount is available.

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

226 Comments

  1. kellidon on May 7, 2010 at 1:28 pm

    Ed… My penalty is 7800. The penalty is based on my current rate and my current discount as well as the closest rate to the term I have remaining. In this case it is two years. So the penalty is based on 5.19 – (4.15-1.40) = 2.75 127000 * .0275 / 12 * 27 = 7858. Now am not sure what you said to your other client whose rate was 5.19. I am no expert but it appears my penalty is 2.75% on my entire mortgae for 27 months. If todays one year term rate is 3.40. I am paying. 5.19 – 3.40 = 1.79% less for 27 months. But I had to pay 2.75 per month in order to get the lower rate. As well I don’t know what the one year rate will be next year. I could also do a open variable at 2.25 ( 5.19 – 2.25 = 2.94) This option would save me money (2.94-2.75= .19% per month) But we all know prime is going up. Some say up to 2.50 – 3.00 within the next 18 months. Even waiting for a bigger discount on prime doesn’t do much good becuase you are just getting a bigger discount on a higher prime lending rate. If you could please email me your calculations on how you think its beneficial to pay penalty. Thanks

  2. SoloWoman on May 7, 2010 at 4:07 pm

    Ed,

    Thanks always for your thoughts. What additional costs are incurred with each (yearly) renegotiation. For condos, for instance, the ones that I can think of off the top – status certificate $100, appraisal(2-300?), legal for new mortgage ($700), legal for discharge from previous bank/fin inst ($275-400). How does that factor with the negotiations every year? Doesn’t that eat up a couple of pts? Just curious.

  3. bob on May 7, 2010 at 4:38 pm

    Again, you still have not addressed the negative equity issue with 1-year fixed mortgages.

    Currently, prices are high. Virtually all economists are predicting higher rates and a drop in housing values. Some have even suggested a dramatic drop in house values.

    With a one-year fixed you had better have enough equity when you buy to prevent yourself from going into negative equity after home prices drop. Otherwise, you will not have access to the deeply discounted Variable Rates when your mortgage comes due. And, if you still don’t have 20%, you will have to start paying CHMC insurance. This can all add up to a lot of money.

    And, sorry Ed, but I simply do not believe you that Banks will not ask you for an assessment at each renewal. The BMO mortgage fraud case is just another reason why such assessments have become standard operating procedure — even on renewals.

    I’m also still waiting to hear who these lenders are that will let your VRM payments stay fixed, even if it results in your payment not covering the interest. Link?

  4. Palooza on May 8, 2010 at 2:01 am

    OK, here’s a question Ed. Given today’s marketplace, what rate would convince you to take a 5-yr fixed?

  5. Ed Rempel on May 8, 2010 at 5:15 pm

    Hi Catherine,

    Thanks for the support!

    I agree. Why pay more interest than is necessary?

    It’s good you didn’t split the mortgage. Splitting the mortgage is another trap used to lock you in. Having half in a 5-year fixed is the same trap as having it all in a 1-year fixed.

    If you go half 1-year and half 5-year, then you still lose your flexibility and negotiating power. When the 1-year comes due, the bank knows you are stuck with them. You can’t move anywhere else without paying the penalty on the other part. you may well find that the bank doesn’t even offer you much of a discount.

    Thanks again for the support.

    Ed

  6. Ed Rempel on May 8, 2010 at 5:19 pm

    Hi FT,

    I agree. Many people take the 5-year fixed just to avoid the hassle of renegotiating, even though it can be hugely profitable. I can’t imagine that people would not want to spend an hour if it can save them $2-5,000/year after tax!

    But once you know how to negotiate, it’s fun!

    Ed

  7. Ed Rempel on May 8, 2010 at 5:28 pm

    Hi SoloWoman,

    Fees are a factor, but usually a small one – and only usually if you are moving to a new bank. Most of our contacts actually pay part or all legal fees. Some also pay for appraisal fees and others often don’t do appraisals (believe it or not). In most cases, the only costs are the discharge fee and possibly a bit of legal.

    When you compare this as a percentage of the mortgage, it’s usually a small percentage. If you pay between $250-500 total on a typical mortgage of $200-250,000, it is between .1-.25%.

    Some banks will actually charge you fees if you stay with them, if you want to refinance in some way or reappraise for a large mortgage or credit limit. In these cases, it may cost as much or more to NOT move a mortgage.

    Ed

  8. Ed Rempel on May 9, 2010 at 5:29 pm

    Hi Kelidon,

    Okay, let’s do the math & see whether or not it makes sense for you to break your mortgage. Your penalty is $7,800.

    If you keep your mortgage, the interest you will pay to maturity is $127,000*5.19%*2.25 years = $14,830.

    Today, we are getting 1-year fixed at 2.35%. After adding the penalty to your mortgage, it will be about $135,000. So, in year 1, your interest is $135,000*2.35%=$3,170.

    So, to break even, in the remaining term, you need to interest less than $14,830-7,800 penalty-$3,170=$3,860.

    At that point, you have 15 months (1.25 years) left. So, the percent you need to be below is $3,860/1.25=$3,090. Divide $3,090/$135,000=2.3%.

    So, what are the odds that you will be able to renew in a year at or below 2.3%? Probably very low. That is a tad lower than today, and we expect rates to rise.

    In your case, you are trapped!

    It does not really make sense to break your mortgage, unless you have other reasons to refinance, such as rolling in more expensive debt.

    Any rate over 5% is quite high, so you would think it would be worth it, but sorry, you have to work this out individually for each person’s situation.

    Did you actually call the bank to get your penalty, though? Or did you just calculate it? You need to call to get the actual penalty, because it may differ quite a bit from your calculation.

    And don’t believe it if they say it will take them a day or 2 to get the number. It is right there on their computer screen.

    Different banks calculate IRD differently. The calculation you showed is one of the most punitive.

    5-year rates are normally higher than 2-year rates and you can normally get a larger discount on a 5-year rate. So, comparing your existing rate to today’s 2-year rate minus the discount your received on your 5-year mortgage is quite punitive.

    It might help to recalculate again when there are about 19 months left. Then they are still comparing to the 2-year rate, but the IRD is calculated over a shorter time period.

    Anyway, in your case, Kelidon, if your penalty number is correct – you are trapped!

    Ed

  9. bob on May 9, 2010 at 8:50 pm

    Ed

    Still no discussion of negative equity risk with 1-year mortgages?

    And still no link to the lenders who will allow fixed payments in VRM that do not cover interest payments?

  10. Ed Rempel on May 13, 2010 at 12:22 pm

    Hi Bob,

    All I can tell you is that we had clients in 2006 where the rates had risen and the payment on their variable mortgage did not even cover the interest, but the bank just left their payments the same.

    The banks also still mail out a form for a straight renewal, so people could just sign it and renew, without a credit check, appraisal or anything. Nobody should ever do that, since the renewal letters are the posted rate. We have had no trouble getting a renewal at the lowest rate for people that lost their job during the year, and the bank to my knowledge has never asked about the home value on a straight renewal.

    I called a couple bank contacts to ask them at what specific point they might increase a payment if the mortgage balance keeps going up and have been waiting to hear back, so I could quote the exact rule. This kind of info does not seem to be on their web sites.

    As a mortgage broker, have you done straight renewals, Bob? Unfortunately hardly anybody compensates mortgage brokers for servicing existing clients on a straight renewal, unless they refinance or move their mortgage.

    All I can tell you is that none of these things have ever been an issue for us, Bob.

    Ed

  11. bob on May 13, 2010 at 2:18 pm

    For the fourth (fifth?) time I’ll ask: WHICH LENDERS are you talking about? Because this is NOT standard practice in 2010 as far as I can tell. To get discounted (and even posted rates) now, appraisals are required. And people with average incomes who are underwater on their mortgage don’t get offered the best rates. Period. Unless you can tell us specifically who operates differently . . .

    Why are you so reticent to tell anyone exactly which lenders you are talking about? Is it because you are getting special treatment that isn’t available to regular consumers? If so, you need to tell us this, because you present your advice as if it is applicable to everyone, not just your own clients. If your advice is only applicable to “special deals” that only you can get, then it is misleading to pretend that it should be applicable to everyone.

    As I stated above, I am not a mortgage broker. I’m a mortgage consumer, so implications that I’m simply interested in the topic as a means to line my pocket are way off the mark.

    I’m interested simply because I don’t think you are presenting both sides of the coin fairly.

  12. Tster on May 13, 2010 at 4:22 pm

    Ed…

    I am not sure what “banks” you are dealing with, but I can tell you for a fact that your comments in regard to renewal documents being printed with posted rates is absolutely incorrect. You continue to make general statements leading the readers of this article to believe that you are an expert when it comes to the neogiation practices of banks and brokers in general. Statements such as the one above along with others such as access to credit and negotiating power being better by being in a variable rate mortgage are misleading and have no truth to them. You have also reccomended to one client who had a interest rate of 5.19 to break there penalty yet another poster wtih the same interest and I would assume a very similiar term remaining, it was not worth it to break. Plus no mention of the interest cost over 25-30-35 years for people who add penalties onto the mortgage. This is simply bad advise.

    There is not one person who has an interest rate higher than todays current posted rates that would not love to have a lower rate. The fact of the matter is, there is no-one that can predict for certainty what rates will do 1/3/5 years out. The reality you fail to see in your standard advise to all clients is, that everyone loves the low rates when prime is low / 1 year fixed is low. They state that they understand the risk…. yes risk… asscociated with being in a short term mortgage. It isn’t until the next year comes, and prime has increase by 2% 1 year fixed increased by 2% that people truly understand what their appetite for risk is. I am not sure how many clients you have the opportunity to sit with after setting them up in variable rate mortgages when it comes time to renew and they find out their amortizations have skyrocketed due to increasing prime lending rates. I can tell you for a fact, being in the business for 15 years that client have a much different attitude when rates have gone up or equity markets have gone down. When you remind them of conversation you have had in the past, their memories become very selective on what the remember or do not remember.

    Your posts are becoming commical to say the least. I have stated in the past that your advice is “cooker cutter”. You believe that all clients can accept the same amount of risk… yes risk… when choosing terms for mortgages. I would really love to hear what you recommend to clients in regard to retirement portfolios. Does a 20 year old and a 60 year old have the same portfolio? Is it best to go with 100% equties, since over the long term they will outperform bonds. This is the basis of you argument with variable rate mortgages. I don’t believe anyone has disputed that fact that over the long term Variable will provide a great amount of interest saving vs a 5 year fixed. So please let all your readers know. Is you advice in regard to investments such as stocks, bonds, mutual funds, GIC the same garbage you spew about mortgages. I really don’t expect an answer to this question or the one that Bob has asked mutiple time. Becuase to be very honest I don’t believe you have one that fits with the advise you give.

  13. Ed Rempel on May 14, 2010 at 12:28 am

    Hi Bob,

    Sorry, I thought you were a mortgage broker. You sound like you are speaking from experience.

    We have a variety of mortgage contacts, but the vast majority of our mortgage referrals have gone to the banks, such as TD, BMO or Royal. My hesitance to name them in response to your questions is because I don’t actually know all the answers for each bank – and neither do our mortgage contacts. Specifically for your question about what happens if rates rise so much that they don’t even cover the interest, our bank contacts are telling me this has never come up. They have had to talk to people at head office to try to find the answer.

    For example, our today’s rate of 2.35% with a 25-year amortization and a $100,000 mortgage would be a payment of $441/month. In order for this not to cover the interest, rates would have to rise to 5.35%. Rates would have to more than double.

    BMO was our main source of variable rates (before they eliminated their excellent 3-year open variable in an SM mortgage). Our BMO contact has been in the industry for more than 20 years and has never come across this issue. I have heard now (but not confirmed) that BMO will increase your payment if the mortgage principal reaches 105% of the original mortgage.

    For this to happen, rates would have to rise to more than 5.35% and stay there for quite a while. It seems that this has not happened in the last couple decades.

    I asked our various contacts, but don’t have answers from most yet. It seems every bank has different rules about this.

    You asked about renewals, but those aren’t an issue. BMO & TD have confirmed that they never do appraisals, credit checks or income verification on a straight renewal. You are free to negotiate whatever term you want, as long as it is a straight renewal.

    Getting the best rates is a matter of effective negotiation, which generally can be done on even on a straight renewal.

    You asked if we get special treatment not available to the general public. That’s a good question. I don’t think so. I have always thought that it was just the way we negotiate. We do refer a lot of mortgages, know exactly what to ask for, and are very focused on the term that we believe is the smartest at any point in time. I’m pretty sure, though, that anyone with a good credit rating that was good at negotiating mortgages should be able to get a similar rate & terms.

    Ed

  14. Ed Rempel on May 14, 2010 at 1:35 am

    Hi Tster,

    Having a 1-year or variable mortgage clearly gives people more negotiating power and flexibility than a 5-year fixed. With a 1-year, your mortgage comes due every year and you are free to negotiate or refinance any way you want – with no penalty.

    If you are in the middle of a term and have a large penalty to break your mortgage, your options are limited. If rates drop and you want to take advantage of the lower rates; if you need to refinance some other debt; if you want to move; or whatever – having a large penalty is a big problem.

    You might be able to negotiate a bit with your existing bank or add a second, but your options are limited – and your bank knows your hands are tied!

    Even with a 5-year variable closed, penalties are quite often much less than with a 5-year fixed, so the restrictions on your options are reduced.

    The 2 clients with existing rates at 5.19% turned out to be quite different situations. They had different number of years until their term came due, different mortgage companies, and more importantly a huge difference in the penalty they would have to pay.

    When we calculate whether or not it is beneficial to break a mortgage (we call it “Ed’s Mortgage Breaking Calculation”), it is only the difference between the 2 options during the term that matter. The interest over the next 25 years is not relevant.

    For example, if someone has 2 years left in a 5-year fixed and the penalty to get out is $6,000, but best estimates are that they would save $10,000 in interest by taking a new low rate, then breaking the mortgage is probably worth it.

    Calculating the interest on the $6,000 penalty over 25 years is not relevant, since they saved more than that during the term. Even with the penalty added to the mortgage, they end up with a lower mortgage balance at the end of the term.

    The risk is generally lower with a 5-year variable with fixed payments than with a 5-year fixed. In both cases, you have a constant payment during the 5 years, which is the main concern about risk. At the end of the 5 years, in both cases, you need to renegotiate at that time.

    The lower risk effects of the variable are that the penalty to get out is quite probably much less, so the risk of something happening in your life where you would benefit by refinancing is lower. You are less trapped with a 5-year closed variable.

    Also, if you choose the same payment, you have a 90% chance of having a lower mortgage balance at the end of the 5 years, so your renewal payment will probably be lower.

    The 1-year fixed is not a lower risk option. It is the option that we think will save the most money right now. We think it is the best option for the vast majority of people for whom saving money is the most important issue.

    There are other ways of dealing with interest rate risk, as well, other than trapping people for 5 years. Having an emergency fund (savings or available credit line) in case payments rise and education about the savings and risks usually give people the confidence to make the choice that will most likely save them lots of money.

    It is probably true that some people might not remember your explanations later when interest rates are higher and may blame you, but we haven’t really had a problem with that. Most of our clients are more interested in saving money. And I guess they realize our advice is not a guarantee of savings and that we are genuinely trying to help them save money.

    We also see educating the public and our clients about mortgages and how to save money as a mission. The odds are so strongly against 5-year fixed. If you take 2 in a row, I’m sure the odds of saving money by avoiding the 5-year fixed are 100%. And we think that most of the reasons for taking them are exaggerated fears of unlikely events.

    We think that the percent of Canadians that should take a 5-year fixed is somewhere between 0% and 10%, but it seems that about 70% are taking them. We think the reason they take them are lack of education.

    It is easier to let people take the 5-year fixed that most ask for, but we think that the right thing to do is to spend the time to educate people, quantify the potential savings and the risks, and then give them a recommendation that fits their situation, so that they can make an educated choice.

    Ed

  15. Ed Rempel on May 14, 2010 at 1:50 am

    Hi Palooza,

    For us to recommend a 5-year fixed, we would need to expect to save a significant amount to compensate for being trapped.

    Of course this choice varies by client, but if the goal is to save money, then for most clients, there is a benefit of having the flexibility and negotiating power.

    To put a number on it for a typical client, we would want to be at least .5%/year lower than the average interest rate we would expect over the next 5 years from using the combination 1-year/variable strategy.

    Since our best guess is that the average of the next 5 years by taking whatever is best between 1-year and variable would average between 3.5-4% (taking into account that we can get 2.35% for year 1), we would probably want to be at least .5% lower than that before we would start seriously considering a 5-year fixed.

    Ed

  16. ron on May 14, 2010 at 12:13 pm

    Tster The last time i received an offer to renew from my bank it was the ridiculously high posted rates that were offered. This was 6 years ago, maybe the banks have terminated this practice. Have to wonder how many unsuspecting people were victims.Every post from Ed has been 100% correct,it has to be its math.If you want the security of a fixed there is a premium to be payed. with me its a risk reward thing and i plan to convert to a fixed shortly as i no longer have appetite for the risk. Tster sounds to me like your a loyal bank employee,if so your going to hate my closing comments. All to often in dealing with bank “specialist” i have found the individual to be less knowledgeable than myself.This applies to investments as well as mortgages. perhaps if my net worth was higher id get the guy with the masters degree. This has never been the case with my broker. My advise to all.Find a reputable broker, take his best rates to your bank and if they offer to match say no thanks ill go with my broker.that and by etfs not mutual funds

  17. bob on May 14, 2010 at 2:39 pm

    My hesitance to name them in response to your questions is because I don’t actually know all the answers for each bank – and neither do our mortgage contacts. Specifically for your question about what happens if rates rise so much that they don’t even cover the interest, our bank contacts are telling me this has never come up. They have had to talk to people at head office to try to find the answer.

    Frankly, I find this very difficult to believe. All of the information is available on the Banks’ Mortgage websites.

    This, for example, is from TD’s website:
    “Should interest rates rise, more is applied toward interest. If interest rates increase so that the monthly payment does not cover the interest costs, you have the option of adjusting your payments, making a lump-sum payment or paying off the balance of the mortgage.”

    Here is from National Bank’s website
    “Fixed payment: this option facilitates budget planning and allows for a larger payment on principal. The fixed payment amount may be revised if it no longer covers current interest expenses.”

  18. Tster on May 14, 2010 at 4:03 pm

    Ron,

    Thanks for your comments. I do work for a bank, and I understand that their are both good “specialist” and bad that work for all FI. This comment must apply to brokers as well! You can’t really believe that all Mortgage “specialists” that work for a bank are bad and all brokers are good do you? If you are looking for a reputable broker, is not possible to find such a person that works for a bank. Am I a loyal banker? I will glad say yes. I don’t believe in everything my bank and other do but I am not sure if any employee can truly say they support their employer 100%.

    It is articles such as these that bring readers out and encourage them to “bash the banks”. Comments that refer to huge profits, making money on service charges and Ed’s comment that bankers “push” 5 year fixed to make their banks more money are absolutely not the case. As a Canadian would you rather deal with a US bank which is losing money? How safe to you feel depositing your paycheck? Do you drive through Tim Hortons and rip a strip of the young lady that is handing you your coffee becuase their profit was up 25%?

    You speak of how many “victims” there have been with clients that sign mortgage renewal documents without negotiating better rates. I take exception to comments like these. Who’s job is to ensure client read their mail? Does the bank need to phone every client to remind them of something which should be common sense? Whether I work for a bank or not, I think it is common sense to read my mail and if I don’t, I only have myself to blame. Is it Safeways job to ask every client if they clipped a coupon for 75 cents off their cheese purchase?

    Ed’s comments are not all correct. He speaks as an expert to banks and broker which he is not. I will give one example from many I have read. Ed states you gain negotiating power with shorter terms mortgages. “You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service.” This is so far from the truth. In Canadian banks you must QUALIFY for credit… it isn’t handed out becuase you took a 1yr term over a 5 year term. Appraisal fees are negotiated based on the strength of a client not which term he/she selects. Why would ED make a comment like this and lead every single person who reads this article to believe that if you choose a variable or 1 yr term you can get a free appraisal!!! Absolute garbage, plain and simple

    I like your investment strategy… I do have mutual funds and have done quite well on them just about a 20% annual return over the past 15 years… And thats a mutual fund (sector fund). I am sure you would agree though, that just becuase I can handle the fluctuations of what this fund can do, doesn’t necessarily mean my 20 year nehpew could or my 70 year old father!!! Once again Ed believes ALL clients should be in in 1 year fixed or variable. I guess this makes for easy advise.

  19. DogsFan on May 18, 2010 at 11:23 am

    Does anyone have thoughts on holding your entire mortgage inside a LOC? Even at prime+1 you may come out ahead due to the fact that LOC’s charge simple interest rather than compounding.

    Do any of the spreadsheet enthusiasts care to run the numbers?

  20. YYC81 on May 18, 2010 at 11:35 am

    @DogsFan
    No .. it doesn’t work like that. If you’re making payments towards interest every month, you’re paying compound interest. $200,000 @ P-0.5% will always beat $200,000 @ P+1.00%. Always.

    There’s an argument to be made for holding a small portion of your mortgage on a HELOC and using your regular cashflow to largely eliminate the interest charges (pay down HELOC with your paycheques, pay expenses out of HELOC as they come due). I haven’t really played with the numbers enough to see how worthwhile that would be.

  21. Smartguy on May 18, 2010 at 12:29 pm

    @dogsfan

    This is the type off approach used by mortgage acceleration programs. Using this approach you can pay off your mortgage in half the time and save a ton off money. It does require fiscal discipline but not extra payments per se. I tried to link to a site describing the SmartEquity program earlier but was not allowed. If you want more info send me an email and I can give you the link. Here is an article that describes these types of strategies http://activerain.com/blogsview/600420/mortgage-acceleration-programs-explained

  22. Ed Rempel on May 19, 2010 at 2:10 am

    Hi bob,

    I don’t think those quotes from the bank web sites are what you think. TD sends a letter to clients with every interest rate increase asking whether you want to increase your payment to keep the amortization the same. This is your option – not a requirement from the bank.

    Ed

  23. Ed Rempel on May 19, 2010 at 2:48 am

    Hi Tster,

    I don’t think that ALL clients should take 1-year fixed, since saving money is not the most important thing for all clients. However, I do question mortgage reps when most of their customers are in 5-year fixed.

    They are more profitable for banks because of higher interest and less cost of doing renewals, and bankers on bonus programs or mortgage brokers on commission, they usually pay better.

    I don’t know exact numbers, but we have heard figures of roughly 70% of Canadians being in 5-year fixed mortgages. I would suggest that the majority of these people received bad advice.

    We are often approached by mortgage people wanting to be our source. We only want to work with people that we believe genuinely have their clients best interest at heart and that will follow our recommendations.

    One of the simple tests we use is that we don’t work with mortgage people that have most of their clients in 5-year fixed.

    I’m not bashing banks in general. Our Canadian banking system is quite good. But people should realize that when they are negotiating with a bank, they are negotiating AGAINST the bank. The higher rate you take (generally), the more money the bank makes.

    What I meant to say in my previous post is that you can CHOOSE whatever term you want on renewal. If you are trapped in the middle of a 5-year term, you are not really in a good position to negotiate, since the bank knows you would have to pay a penalty to refinance or leave.

    But when your term comes due, you are in a much stronger position to try to negotiate. We have seen people negotiate lots of goodies when their term comes due – lower rates, your choice of term, free appraisals, unsecured credit lines, occasionally bank fee reductions etc. are possible things you can try to negotiate for that we have seen people get. Of course you need to qualify and some banks are much less likely to offer any of these goodies, but we have been able to negotiate most of these relatively routinely for our clients.

    This is why you have so much more negotiating power and flexibility with a 1-year or open mortgage. Every year, you can try to negotiate for the best deal and possibly some extra goodies. With some experience, this can be fun and profitable.

    The mortgage industry is quite competitive, so if you don’t have a penalty to pay, you are free to negotiate with any bank and can easily move to whichever one gives you the best offer.

    Ed

  24. Ed Rempel on May 19, 2010 at 2:56 am

    Hi DogsFan,

    Credit line interest is monthly compounding, since it is charged every month. It is simple interest for the month, but is then charged every month, which is the same as monthly compounding.

    Most mortgages are based on a formula that is semi-annual compounding. This means the mortgage would have LESS interest than a credit line at the same interest rate.

    This is generally not true of readvanceable mortgages that are within a credit line, but they offer other advantages (such as you can use them for the Smith Manoeuvre).

    YYC81 is correct that you can get a variable BELOW prime, which will always be cheaper than a rate above prime.

    Ed

  25. Ed Rempel on May 19, 2010 at 3:11 am

    Hi SmartGuy,

    Mortgage acceleration programs don’t really work, except possibly if your income comes in huge lump sums during the year or if you are the type that keeps $50,000 in your bank accounts.

    Perhaps you are referring to something else, but the ones shown in the article are:

    1. Just paying more in each payment to reduce your amortization.
    2. Having bi-weekly mortgage payments. This actually only saves you money if you are paid bi-weekly, if you include the cost of carrying dormant cash in your accounts waiting for your next mortgage payment.
    3. Using an Australian mortgage. This is like Manulife One. They allow you to essentially always have your bank balances combined with your mortgage, so you owe less. If you do the math, the savings are usually not that high. For example, if my average bank balance is $2,000 and my mortgage interest is at 2.5%, then I only save $50/year by “combining all my inefficient accounts into one”.

    In addition, Manulife One has relatively high monthly fees and is generally not at all competitive on the mortgage rate, compared to what you can get by shopping around. The monthly fees and especially the mortgage rate are usually much more significant factors.

    Ed

  26. bob on May 19, 2010 at 9:56 am

    Hi bob,

    I don’t think those quotes from the bank web sites are what you think. TD sends a letter to clients with every interest rate increase asking whether you want to increase your payment to keep the amortization the same. This is your option – not a requirement from the bank.

    Ed

    Aaaarrrrgghh. I’m done with this conversation because you consistently misrepresent things.

    Whether TD asks you whether or not you want to increase your payment to keep your amortization the same when rates change has absolutely nothing to do with what they will do when rates rise so high that your payments do not even cover the interest.

    You made several claims in this thread such as (1) your payments in a VRM will stay the same even if they no longer cover the interest and (2) that you were finding it difficult to find out what happens when interest rates rise so high that they no longer cover interest.

    The first one is just false, and the second one is suspect given that it is on the bank’s websites.

    Contrary to your claim, the TD website says explicitly what happens when your fixed payments no longer cover the interest:

    If interest rates increase so that the monthly payment does not cover the interest costs, you have the option of adjusting your payments, making a lump-sum payment or paying off the balance of the mortgage.”

    Note that you do not have the option to keep your payment the same. It is very nice that they let you adjust your payments to keep your ammortization the same with “regular” rate rises. But if your payments no longer cover the interest, you have no option to keep your payments the same. Contrary to what you say, this is a requirement of the bank.

  27. Ed Rempel on May 20, 2010 at 1:38 am

    Hi again, bob,

    The new mortgage rules for qualifying for a mortgage support the 5-year variable as the safe choice, instead of the 5-year fixed.

    Even though you can get a variable at 1.75% today, you must qualify based on the posted 5-year fixed rate of 6% or more. This should mean that if rates rise by 4.25%, the variable would only rise to 6%, which is a rate you should be able to afford – since you already qualified for the mortgage based on that rate.

    So, there are 2 types of risk:
    1. Mortgage rates rise making your payment rise.
    2. Something happens that causes you to want to refinance.

    The 1st risk will now be small, since people have to qualify based on rates more than 4.25% higher than today’s rate.

    The 2nd risk is much more significant and one we have seen far more often. Something happens to make you want to refinance – such as you want to buy a car, you ran up some debt at higher rates, you lost your job and need to borrow based on only your spouse’s income, you want to move, etc.

    In any of these cases, having a potentially HUGE penalty may make refinancing impossible.

    People seem constantly worried about “what happens if rates rise and my payment is increased?” We have not actually seen this happen.

    But what about the worry of “my spouse lost her job and we need to refinance our credit line or car loan so we can still make payments?” We have seen that type of incident happen quite often.

    That is, in our opinion, the biggest risk of mortgages for those barely scraping by on their payments. This is why, for most people that are barely scraping by, the 5-year variable with a fixed payment is safer than the more risky 5-year fixed – especially now under the new mortgage rules.

    Of course, for probably 90+% of people that are not barely scraping by or have some sort of emergency fund or available credit, saving money on their mortgage is the biggest issue.

    Just to be clear, again, we are recommending the 1-year fixed today – not the variable for most people. We see the best mortgage for most people based on their objective as:

    1. Save money on your mortgage – Take 1-year fixed (until we get larger discounts on variable).
    2. Avoid risk of losing home – Take 5-year variable with a fixed payment, especially an open variable (and keep more options of refinancing).

    Note that in both cases, the 5-year fixed is likely not the best choice.

    Ed

  28. Ed Rempel on May 20, 2010 at 1:42 am

    Hi bob,

    Maybe you are right. I’m not misrepresenting anything – just telling you what our bank contacts are telling us.

    We don’t just look at web sites. We talk to the experts. Since we have a mortgage specialist we work with all the time at various banks, why would I try to interpret what it says on their web site?

    Our TD contact told me that they always send the letter giving you the option of increasing your payments any time prime rises. She has not yet confirmed your interpretation of the quote you found on their site, but your interpretation sounds right.

    Our BMO contact confirmed that they increase the payment “if the loan balance exceeds 105% of the authorized loan amount.”

    The mortgage document states:

    “If the interest rate increases to an estimated _____% per annum, the Borrower’s first scheduled payment will not cover the interest that has accrued and become payable to the date of the Borrower’s first scheduled payment… As the Borrower’s payments are not adjusted automatically to reflect changes in the interest rate, negative amortization may occur.”

    The reference to the first payment is because each payment reduces the principal, so it would take a larger rate increase before the 105% of the approved amount is reached.

    We are trying to figure out exactly how high rates would have to go before the bank would increase the payment on a variable mortgage. We can get a variable today at 1.75% (prime -.5%). For a mortgage of $100,000 with a 25-year amortization, the payment would be $412/month. For rates to rise so that interest is $412/month, the rate would have to rise to 4.95%.

    That would be a rate increase of 3.2%. If you are right, TD would increase your payment if rates rose MORE THAN 3.2%.

    At BMO, rates would have to rise more than 3.2% plus increase the mortgage principal by 5%. That would mean, for example, an additional 5% for 1 year or 2.5% for 2 years. So, rates would have to rise by 8.2% and stay there for 1 year or 5.7% and stay there for 2 years, etc.

    I guess that is why our contacts did not know the answer and said they have never seen a case where the payment was increased.

    I can also say that in 15 years of referring people for a mortgage, I can’t think of a single case when a mortgage payment on a variable was increased.

    We don’t deal with nearly all mortgage companies, so if having a payment increase is the major issue for you, then you should ask the mortgage person exactly how high rates would have to go before they would require a higher payment. See if your mortgage rep knows how high rates would have to go! :)

    Ed

  29. tster on May 20, 2010 at 11:34 am

    I am trying to understand why you continue to talk about how variable offers clients flexibility. Your two main arguments for 1 year or variable are:

    1/ Save money on your mortgage – I agree with this point. I am not sure that offering this advise to all client in all financial circumstance is the best thing to do. It is your blanket approach and you have made that clear. I am surprised however that you would offer this to the majority of your clients yet you cannot explain to them the biggest risk associated with a variable mortgage. Will payments increase as prime increase? Will payments increase once the trigger rate is achieved? How does increasing prime affect my amortization? These all seem to me as being basic questions on a VRM. You cannot focus soley on the fact that over history a VRM safes clients money without also disclosing to them that in order to get to that end scenerio there will be some heavy fluctuations in payments. Prime over the last 25 years has ranged between todays lows and 11.50%.

    2/ Avoid risk of losing home – Clients who get in to trouble with high interest credits, loans that they wish to pay, education cost for kids or investing…. whatever the expense is. Fixed rate mortgage can be added onto WITHOUT PENALTY. Clients can blend existing terms with a new term on the new portion of funds added to mortgage. You cannot add-on to a VRM without closing and reopening the mortgage. This mean that “deep discount” you may have had on the mortgage you may not be able to get… especially if economic factor play into you cash crunch… It those times spread are usually low as we have seen in the last 18 months and dicounts on VRM are non-existent. And you final point about someone who loses their job, which is the worst case scenerio. Clients in either case would have to requalify for for EITHER a VRM or a FRM. How does a VRM add flexibility to a client that does not qualify.

    As I have said in the past…. and I work for one of the banks you use… A client is in no better position to negotiate on a 1 year deal or variable which in most cases in a non-negotiable product. Why…?? the risk to the bank is greater as the mortage could walk out the door tomorrow ( in a case of a variable open or next year (in the case of a one year term.) You like hockey analogies. What are the chances that Kovalchuk will shop himself around for a 1 year contract? Very low, and the reason why is he risks losing the security of a long term contract that gaurantees him income in the event of an injury. Now remember Kovalchuk is the best UFA out their… he has lots of negotiating power as do clients that have equity, RSP, Investment, job stability. Most banks will not give more discount without the client agreeing to bring more business. You have talked about it before. It is not tied selling it is relationship pricing!! What I am getting at is that hockey players like clients are in positions of strengh in negotiation based on what they bring to the table not by the fact that they just play hockey or hold a mortgage…

  30. ron on May 20, 2010 at 8:31 pm

    tster Eds a big boy and does not need me to defend him however he has already stated that his suggestions might not be for everyone. How can you suggest that a short term rate does not improve your flexibility. 120 days before the end of the mortgage i can lock in rates for any term with many institution Technically im only locked in for 245 days in a one year fixed. If i encounter hard times i can bail without an excessive penalty for doing so.If im in a variable and rates look like there getting out of hand i can lock into a fixed.

  31. tster on May 21, 2010 at 2:15 am

    Ron

    I have never said that a 1 year term or VRM is not flexible… I did say the following: “How does a VRM add flexibility to a client that does not qualify.” This statement is absolutely correct. A variable rate mortgage to a client that does not qualify is no more flexible than a FRM with the exception that you can get out without penalty. In other conditions you would be a fool to not believe that an open or short term mortgage is more flexible. My point to Ed was that it doesn’t add negotiating power to you position. Your negotiating power is reflective of what you can bring to the table. Ed has made it very clear that 90% of people should be in VRM. So in every comment that has been made not once has he stated that the client should take a FRM of longer than one term. So her HAS said that VRM are for everyone. It was even asked to him if he would give the same advise to a 70 year old as her would to a 25 year old. A question he never answered. As well as what his suggestion would be for investment and telling client to all be in equities instead of bonds since in the long run the will make more money… Another question he never answered.

    You are correct in your 120 day early renewal… But you must renew to a fixed rate term with the financial insitution that holds you mortgage. I know you CANNOT early renew to a VRM open… but need to check on a VRM – closed. Once again I am not sure how much negotiating power you have when the bank knows that the mortgage must be renewed with them. And with the majority of client not having any idea of when the mortgage renews and in some cases signing renewal documents without even talking with their FI… that leads me to believe that the vast majoirty would not go out and apply with other FI’s in order to hold their rate until their mortgage could actually be moved.

    Don’t get me wrong Ron. I suggest VRM to many clients. But it has to fit their lifestyle taking many things into accout including thoughts of building (not moving since mortgages can be ported), future education cost, debt levels, equity levels, job stability. I believe VRM are the best way to go…. but thats for me personally. I would not make statements that suggest that all clients should be Variable and not have the stability of a fixed rate in a rising interest rate envirment.

  32. Ed Rempel on May 26, 2010 at 8:17 pm

    Hi Tster,

    Just to be clear – you are agreeing with me that a short term or open variable mortgage is more flexible – for those that qualify for a mortgage – right?

    Then you must agree that someone with a mortgage due is in a better negotiating position than someone trapped in the middle of a term – right?

    Two things that we think people should never do is “port” a mortgage or “blend and extend”. Both these end up adding an additional amount at the posted rate. You can’t really negotiate that. Posted rates are for losers!

    I understand you point about the mortgage needing to fit the person. But do you agree that the vast majority of people are better off avoiding the 5-Year Fixed Mortgage Trap, Tster?

    It’s hard to put a number on it, but I would estimate about 90%.

    In short, we think that 5-year fixed is the “Poor Man’s Mortgage”. It is for the desperate, poor and fearful that have not set up any emergency funds, don’t qualify for a credit line for emergency use, are “2 pay cheques from bankruptcy” and are willing to pay thousands more in order to avoid an unlikely chance of a larger increase. They are for pessimistic people.

    Variable and 1-year mortgages are for financially stable people. They are for people that want to build wealth or save money, that are not on the verge of bankruptcy and that have some savings or available credit for emergencies. They are for optimistic people.

    Some people are taking the 5-year fixed now because they think “this is the one time when it might save money”. That is possibly true, if you are willing to lock yourself up for 5 years without being compensated for it.

    Remember, the 5-year fixed is the “Foreclosure Mortgage” largely because of a huge penalty that prevents people that can’t afford their mortgage from selling their home for enough to cover the mortgage & penalty. If they could sell and get out, nobody would let their home be foreclosed on. That is possibly the best example of why being trapped is risky.

    Part of why we don’t recommend 5-year fixed is that our clients tend to be focused on saving for their future and building wealth. They are following a written plan to achieve their goals, so taking a “Poor Man’s Mortgage” would rarely make any sense for them.

    Ed

  33. ron on May 26, 2010 at 9:16 pm

    Ed 5-year fixed is the “Poor Man’s Mortgage”. It is for the desperate, poor and fearful that have not set up any emergency funds, don’t qualify for a credit line for emergency use, are “2 pay cheques from bankruptcy” This was almost me when i bought my home. i still went with a one year term for the first 2 years, then 5 year fixed 4.35% and have been in variable for the last 2 years. I think the guy 2 pay checks away from bankruptcy is better of in a one year (lower penalties to terminate the mortgage) Also a year and a half into my 5 year prime went passed 4,35% but i think i still lost in the end. paying down a variable at the same monthly payment as the 5 year fixed would probably have been cheaper. A lot of people dont want to gamble with their homes and for good reason. unlike las vegas though the statistics are in your favour when you avoid 5 year fixed

  34. DogsFan on May 27, 2010 at 11:08 am

    Hi Ed, I dusted off an old wealth management book the other day…written by Charles Givens (Wealth without Risk, Cdn Edition). You sound a lot like him, sticking with mutual funds, and using leverage to grow your wealth. The one area where you differ is in the 5 year fixed vs. VRM, as he recommends that you go long with your fixed mortgage. Of course, that was written in 1992 after years of double digit prime rate. And being “translated” from American to Canadian, there could have been something lost in the translation, as Americans typically have longer terms anyways. He did have an interesting point on starting out with a 15 year ammortization schedule, in that it only increased your payments by 16% over a traditional 25 year.

    Personally, I’m an advocate of what you are saying with regards to mortgages, as I am in a discounted VRM and plan to renew that way next year, unless the 1 yr fixed is a better deal.

    I’m interested to hear your thoughts on Givens’ approach…even for an old book, some of his strategies still made sense.

  35. bob on May 27, 2010 at 12:40 pm

    Part of why we don’t recommend 5-year fixed is that our clients tend to be focused on saving for their future and building wealth. They are following a written plan to achieve their goals, so taking a “Poor Man’s Mortgage” would rarely make any sense for them.

    And herein lies the problem, Ed. As I’ve noted above, your posts consistently make sweeping generalizations under the assumption that everyone is like your clients.

    Alas, as much as we would like it to be so, the reality is that relatively few people are actually like your clients. Most people do not have the disposable income or risk tolerance to use leveraged investing like the Smith Maneuver. Many people cannot take the risk of payments increasing. We can smugly say “well, then they shouldn’t be buying a house”, but that isn’t going to change the reality that they are buying houses. And if they are so intent on buying a house despite their limited resources, blanket advice geared towards people with significant resources is not likely to serve them well.

    Nobody has disagreed with you that VRM is likely to save money. But, you need to recognize that VRM is not a good fit for many of the people who do not resemble your clients. Like Tster, I find it extremely disconcerting that you do not seem to understand the concepts of “trigger points” for VRM, that you literally say “who cares” to the potential for clients to spend 5-years making payments only to owe more on their mortgage than when they started, and that you do not acknowledge that there is considerable risk to having negative equity in your single largest asset class.

  36. SoloWoman on May 28, 2010 at 7:52 pm

    Thanks Ed & all – This thread and all the banter has been extremely useful in my deliberations. I have nearly closed my refinance and the rates dropped yet again and so I have managed prime -.8 (at 3 or 5). Indeed, it has paid to wait a little, wise up, and to shop brokers not banks. While there may be deeper discounts pending, I feel okay at this time. It is much better than my original 6% (back when I was desperate, poor & fearful). :D

  37. Multiple Egg Baskets on July 2, 2010 at 4:40 pm

    Should a residential and investment mortgage be compared equally?

  38. Ed Rempel on August 4, 2010 at 1:32 am

    Hi Ron,

    Thanks for the comments. You’ve made some good decisions (and learned from others).

    Ed

  39. Ed Rempel on August 4, 2010 at 1:34 am

    Hi DogsFan,

    I have not realize the similarity with Givens. I have a couple of his books, but really only skimmed them years ago. I’ll have to look at them again. You make him sound smart. :)

    Ed

  40. Ed Rempel on August 4, 2010 at 1:47 am

    Hi Multiple Egg Baskets,

    In general, the same concepts for saving money apply to both residential and investment mortgages. Commercial mortgages are a completely different animal and usually much more expensive, but residential investment mortgages are similar to personal mortgages.

    We often hear people being less concerned about the interest cost of a rental mortgage because it is tax deductible, but saving money is saving money. In addition, it is generally smart to pay off a rental mortgage as slowly as possible and focus on paying off the non-deductible mortgage on your home. Rental income is also highly taxed once the mortgage is paid down a lot.

    So, having lower interest rates by sticking with variable and 1-year mortgages might be more important with rental properties, since you may maintain that mortgage much longer.

    Ed

  41. haidar on December 27, 2010 at 12:25 pm

    Hi Ed, I’ve always beleived in short term being better than long term. But with the 5 year fixed at an all time low @ 3.59, compared to variable open @ 3.50, variable closed @ 2.25 and 1 year fixed @ 2.45, i’m starting to change my mind. What do you think? Thanks.

  42. Brian Poncelet, CFP on December 29, 2010 at 1:28 am

    haidar,

    I have been advised clients for 15 years, go one year at a time or variable. See my comments on mortgagetrends.com back in 2007.
    http://www.canadianmortgagetrends.com/canadian_mortgage_trends/2007/07/could-100-oil-s.html

    If you want to pay more and sleep at night go five years fixed. If you want to save… avoid the mortgage broker…bank talk. Remember brokers don’t get paid as much unless you sign for five years vs. one year or less (like open mortgage)

    Brian

  43. Ed Rempel on January 1, 2011 at 1:12 pm

    Hi Haidar,

    I agree that it the savings from going short are less obvious when rates are expected to rise, but we believe that going short is virtually always the best thing to do.

    The reasons we would stay short are:

    1. The 5-year rate is hardly lower than an average mortgage rate in an average market. So capitalize on low rates for a year or 2.
    2. Most likely, the average of the next five years’ 1-year mortgages will be lower than today’s 5-year rate (because it is based on the bond market).
    3. 5-year fixed is the risky mortgage, not the safe one. Fear of a huge rate rise is vastly over-blown, but we have seen so many people pay the penalty to get out of their 5-year fixed.
    4. The flexibility to refinance whenever you want that you have by staying short can be quite variable. We would want a significant clear savings before we would ever consider locking in anything.

    Today we still have very low interest rates. This is a great time to capitalize on them!

    Today’s 5-year rate at about 3.59% is not really much of a low rate. We have been recommending either variable or 1-year and rates have been between 4-4.5% most of the last decade.

    So, 3.59% is only about .5% lower than an average rate in an average market.

    Why not take this opportunity and have a really low mortgage rate? Rates will likely normalize over the next year or 2, but meanwhile, you have saved money for a couple of years.

    Will you save money over the 5 years? You can do some simple math and estimate how much rates would have to rise to be even. If you take 3.59% * 5 years = 17.95%. If you get 2.45% for the first year, then take 17.95%-2.45%= 15.5%, to be even the average of years 2-5 would have to rise to 15.5% / 4 = 3.88%.

    So, rates would have to rise by a bit more than 1.4% and stay there for years 2-5 to be even. Will they? That is hard to say, but most likely not.

    Mortgage rates are based on bond market rates, which are based on the expectations of millions of investors. Bond market investors will always want a premium to take a longer term mortgage. Therefore, 5-year rates will ALWAYS be higher than the expectations of all investors for the average 1-year mortgage during those times.

    Bond markets are far larger than stock markets and bond investors are generally better at forecasting than stock market investors. This is why short term rates have so consistently beaten longer term rates. The one study I saw from a mortgage broker showed that five 1-year fixed mortgages saved money over a 5-year fixed 100% of the time since 1950!

    Many people feel “safer” in a 5-year fixed because of a fear of very high rates, like we had in the early 1980s. Things are completely different now. The main reason for the high rates in the 1980s is pushing rates down today.

    The main reason for the high rates in the 1980s was demographics – millions of Baby Boomers entering the housing market every year and creating huge demand for mortgages. At the same time, there was a very small population of older Canadians that usually buy GICs, so the banks had little money to lend and tons of demand. Rates had to rise to even things out.

    Baby Boomers are still the main driving force in the economy, but they are in their 50s today, so they are more likely to exit the housing market than enter it in the next decade or 2.

    So, we think a large rate rise like that is very unlikely.

    We see 5-year fixed mortgages as risky – not “safe”. The big risk in mortgages is that something will change in your life and you may want to refinance or (heaven forbid) have trouble making your mortgage payment.

    With a 5-year fixed, there is a risk of having to pay a large penalty, which is part of why people with long term mortgages are far more likely to lose their home in a foreclosure.

    The biggest factor, though, is that there is a big benefit in keeping flexibility being able to refinance. You may incur some debts that you could refinance into your mortgage, want to buy a car, move, etc. With a 1-year mortgage, you can refinance for free every year.

    We would want a clear significant savings before we would recommend locking in a mortgage and giving up the flexibility to refinance.

    Ed

  44. Ed Rempel on September 7, 2011 at 10:49 pm

    Hi Everyone,

    For those that locked in to a 5-year fixed at 3.59% 6 months ago, it is looking like it will end up costing you more. Current projections are that interest rates will stay at this level for a minimum of 1 year and probably 2.

    That means that by locking in, you will have paid about 1% more than a 1-year fixed and about 1.5% more than a variable mortgage for all of the first 2 1/2 years of your term.

    Is it too early to chalk up another loss for 5-year fixed mortgages?

    By my calculations, since 1950, the score now is:

    Five 1-year fixed 58
    One 5-year fixed 0

    Avoid the 5-Year Fixed Mortgage Trap.

    Ed

  45. Jungle on September 8, 2011 at 6:50 pm

    Good read. We have about 6 months left and we can early renew for our mortgages. It’s been a long painful road having a 5 year fixed @ 5.14 and 5.5%.

    One thing we have done is paid $80,000 of the mortgage principals. I’m sure that helped save some interest.

  46. Seth on February 1, 2012 at 10:05 pm

    @Ed

    Could you comment on present day scenario (as of Jan 2012) where 5-yr fixed is available for 2.99 while variable is 2.8% and 1-yr fixed being 2.75

    I’m more inclined to take 1-yr fixed but 5 yr looks attractive too (gullible smiley here).

    What would you advice to someone who can handle variable for next foreseeable future?

  47. Ed Rempel on February 12, 2012 at 5:26 pm

    Hi Seth,

    Good question. Today’s mortgage rates are really strange. We are actually getting a 2-year rate that is lower than both 1-year and variable.

    Normally, we just take whatever rate is the lowest, regardless of the term. In most markets, you pay more for longer terms, but the amount you pay is usually expensive given the odds that interest rates will rise enough to save you money.

    The best rates we are seeing today are:

    Variable: prime -.2% (2.8%)
    1-year: 2.69%
    2-year: 2.49%
    4-year: 2.99%

    We are going with the 2-year in most cases.

    The 4-year fixed is intriguing, but the 2-year will save you .5% for 2 years. You will be ahead unless the average of years 3 and 4 are more than 3.49%.

    Like normal, it looks expensive to pay the extra .5% with the 4-year, plus you lose your negotiating power for 4 years, instead of 2.

    It is difficult to know where interest rates are going now. It looks like they will stay low for a couple of years, and they may stay this low longer. Most likely, the economy will eventually come back and interest rates will normalize at perhaps 1% higher than today’s rates. That could happen soon or it could take 4-6 years.

    There is also a possibility that when rates rise, they go too high first before settling down, as well as other possibilities. It is hard to predict rates long term and probably unproductive.

    Generally, you should just go with the lowest rate, which today (for the first time in memory) is the 2-year fixed.

    Ed

  48. Ross on March 2, 2012 at 8:08 am

    Hi Ed,

    Where were you able to find this rate on the 2 year? I am coming off my first year of the SM and about to renegotiate my terms.

    Thanks,
    Ross

  49. Ed Rempel on March 2, 2012 at 3:28 pm

    Hi Ross,

    We are getting it from our contacts at BMO and I believe also TD. If they don’t give you that rate, we can refer you to our contact. Just fill in the “Ed’s Mortgage Referral Service” page on our web site. The link is on the right side above the graphs.

    Ed

  50. Ed Rempel on May 1, 2012 at 12:15 am

    Hi Ross,

    The 2-year fixed is no longer the best deal. It is higher. We think a 1-year fixed is a better deal now. The best deal we are getting is 2.59%.

    As usual, we would not recommend locking in longer term and variable is not competitive now either.

    Ed

Leave a Comment





This site uses Akismet to reduce spam. Learn how your comment data is processed.