Mortgage Terms – Fixed, Variable / Open, Closed / – How does it all apply to todays mortgage market?
Over the past few years many clients walked into my office adamant that they wanted a five-year fixed rate mortgage and nothing else, however very few walked out the door with a five-year fixed rate mortgage…up until the past nine months.
Not one of my clients has taken anything longer than a 5 year term, and often I suggest that a 5 year term is too long. Following are some of the key reasons why this is.
First off let’s get clear on a few definitions;
Closed mortgage – this describes the majority of mortgages, it also implies that there will be a penalty to break the mortgage early. http://dustanwoodhouse.ca/clarity-coming-for-interest-rate-differential-ird-penalty-calculations
Open mortgage – this describes a mortgage that many people think they want, however once they learn more about the interest rate premiums associated they tend to look instead at a closed variable rate mortgage.
Once you have decided upon open or closed (99% of folks go with a closed once the math on actual penalties is done) the next component is the question of Fixed vs. Variable.
Fixed rate mortgage – just like it sounds your interest rate is fixed, or guaranteed, for the length of the term chosen.
Variable rate mortgage – also much like it sounds – the interest rate has the potential to go three ways; up, down, or remain constant. The component of a variable rate mortgage that is guaranteed is the premium or discount from Prime that is established at the outset.
Let’s confirm a few facts about the variable rate product before we go any further;
- There are only eight times per year when the Bank of Canada meets to decide whether or not to move prime rate.
- Your interest rate is unlikely to move by more than .25% following any given meeting ( the Bank of Canada has not moved prime since September of 2010)
- Certain lenders offer a ‘fixed payment’ option – whereby no matter where prime moves to your payment remains constant for 60 months. (this can be an especially effective product for an investment property, or in the case of the client holding a second property which they’re trying to sell)
The third consideration is Term
As ‘term’ applies to a variable rate mortgage this is quite a simple matter as 95% of lenders only offer a 5 year term with their variable. There are a few that still offer a 3 year term for variable rate product.
Current market rates are approximately Prime -.20% with a special discount of Prime -.35% in specific cases
As ‘term’ applies to a fixed rate mortgage there is a wide variety, all with varying rates, current market offerings (OAC);
As you can see above the longer term you choose the higher the applicable interest rate. There is a long-standing perception that the longer one locks in, the ‘safer’ they are. For the most part this perception of safety is not a reality.
The market last year;
18 months ago 90% plus of all files being written in my office were variable. Quite understandable considering that variable rate discounts at the time as deep as .85% below prime (2.15% net) and there appeared no movement in prime anywhere on the horizon. Indeed 18 months later prime still has not moved, nor did it move today, the Bank of Canada’s most recent meeting.
Historically the conversation is always boiled down to five-year fixed versus five-year variable, and once fully educated on the pitfalls, the realities, and the myths of each product 9/10 people chose variable.
But that was then and this is now, the spread between a five-year fixed rate mortgage and variable rate mortgage has narrowed from as much is 2% at one point in time down to as little as .20% at this point.
Many folks look at how close that spread is and say to themselves ‘why would I take a variable that has nowhere to go but up when I can lock in to almost the exact same rate for five full years’.
Indeed for many people this may well prove to be a smart move.
So what this is done for the conversation between me and my clients has change it to something along the lines of;
‘A variable rate mortgage, with its guaranteed prepayment penalty of three months interest, is a wise choice if you think that there is a chance you be selling the property in 18 months or less – otherwise the new conversation is about the length of the fixed rate term you choose to lock into’
(the premium paid to be in an open mortgage currently offsets the three-month interest rate penalty in 10 months or less, historically the crossover point was lows four months – the mathematics of this drive the majority of people into a closed variable rather than an open mortgage when they are contemplating selling a property over the coming year)
It could be argued that today’s ‘new variable product’ is the one year, the two-year, or possibly the three year fixed rate mortgage.
With rates averaging around 2.69% for these products, they are less expensive on a month-to-month basis and a variable rate mortgage. Factoring in significant doubt that prime will be lowered anytime soon, it seems to make more sense to lock in for two years at a lower rate. Come renewal time discounts on variable rate mortgages may well be back to previous levels of prime -.75% or better. Thus the majority of clients who would otherwise choose a
variable rate mortgage are opting for shorter-term fixed rate product.
Statistically speaking approximately 60% of five-year fixed rate mortgages are broken at an average of 38 months. It would be tempting to suggest that the bulk of these mortgages were broken due to the availability of lower rates, however the banks typically structure their prepayment penalties in a way that completely negates any savings from a simple refinance to a new lower rate. For more on this topic click here; http://dustanwoodhouse.ca/clarity-coming-for-interest-rate-differential-ird-penalty-calculations
The short version is that clients currently in five-year fixed rate mortgages with 30-24 months left in their term are being hit with a prepayment penalty of approximately 3% of the mortgage balance. Comparatively speaking the penalty to break out of a closed variable rate mortgage is about .70% of the mortgage balance.
Moving forward if interest rates remain constant, as many (including myself) expect them to these penalty figures will also remain constant.
So why are all those people who are so certain they were going to stay in a five-year fixed rate mortgage breaking out? Based on my own experiences with my existing clients here are just a few of the reasons;
- Marriage (keeping both properties is not always an option)
- Divorce (in many cases neither spouse is able to carry the property on their own)
- The appearance of more children than expected in your household (congrats – triplets)
- Employment issues – transfers, promotions and layoffs can impact where somebody wants to live.
**an important note for workers who have the potential to be transferred to different parts of the province or country, make sure your mortgage is placed with a National lender. Otherwise you may be forced to pay a stiff penalty to a local credit union in Vancouver if you’re transferred out of province. RCMP in particular have to be concerned about lenders that are willing to write mortgages in small town Canada.
- Health issues
- A variety of social issues – gambling, drinking, etc.
- The desire to leverage capital from the property – again for a variety of reasons;
- To start a business
- To fund an existing business
- To pay out high-interest consumer debt
- To cover the failure of the business – without being forced to sell the home
- To raise capital for investment in additional real estate
- To raise capital to help a family member purchase real estate or otherwise
As you can imagine this list goes on. All of these things and more are what we call ‘Life’ and at some point some of this touches all of us, both the good and the bad.
For many of my clients at least one of these items may have been on the horizon at the time we were discussing their mortgage, and so either a shorter term fixed rate product – or even a variable rate product ( due to its guaranteed lower penalty ) has made better sense than a five-year fixed.
Another key issue, which many fail to consider, is the significance of the renewal date.
At the time of this writing, personally speaking, I feel that interest rates are likely to remain constant, within about 0.25% of current rates, for the next two years. I have felt this way since 2010, and have encouraged either variable rate or short term fixed rate product since then.
I am far more comfortable with my mortgage(s) coming due for renewal in 2 years time than I am with them coming due in 5 years time. As it is much more plausible that 5 years from now things will be on the road to recovery and rates may well be 2-3% higher than today.
An additional consideration is that when interest rates do start to rise it is likely that the deep discounting will return in the variable rate product, making it a more attractive option at that time as well.
I look forward to having the option to lock into a longer term product, either fixed or variable, 2 years from now, while enjoying a 2.69% rate in the meantime.
At this point I will reiterate a thought that I put out there regularly;
Ask your banker or your broker what they have done with their own personal mortgage(s) and why they chose what they chose.
On our personal residence we went to a variable rate product in 1996 and have never thought twice about it. At the time I had 25 years of data telling me it was the right move, today I have over 40 years of data to support this choice. Recently a small portion of our residential mortgage came up for renewal and we chose a two year fixed 2.69%, the first fixed rate product we have had on our home since 1995. However I consider it more of a ‘slow motion’ variable. It sidelines a portion of our mortgage for 24 months, or 16 Bank of Canada meetings, and allows us to reevaluate out options in 2014.
In the interests of full disclosure it should be pointed out that brokers and bankers alike are compensated more generously for clients who lock in for longer terms.
If I were to make an argument in favor of my client locking into the 10 year fixed rather than a two year fixed my paycheck triples . However I cannot make that argument as I personally do not believe in it at this time. I prefer to pay that difference in payments directly to the principal, lowering my mortgage balance faster.
Most people’s lives changed quite radically every three years, I know that mine has… since birth.
Have an excellent day!
Dustan Woodhouse AMP