Christopher O Driscoll
Last week in Home Cents, I quoted an RBC survey that found hybrid or combination mortgages are gaining in popularity among Canadians. Several readers wrote asking for more information about this mortgage product. Some also warned that it carries potential pitfalls for borrowers. Given the rising interest surrounding these kinds of mortgages, it's a good time to dig a little deeper into the topic.
Before we get to an explanation of how a hybrid mortgage works, let's put it into context. Most Canadians are familiar with fixed-rate mortgages and variable-rate mortgages.
According to the RBC survey results, most of us still prefer a fixed-rate mortgage, where the rate of interest is fixed for a specific period of time. With this kind of mortgage, you lock in your mortgage interest rate to a specified rate for a term as long as 10 years. The benefits of a fixed-rate mortgage are that your payments stay the same over this time, and you don't have to worry about fluctuations in interest rates. If you're the kind of person who loses sleep over 50-basis-point rate hikes, chances are you'll find comfort in the fixed-rate mortgage.
With a variable-rate mortgage, your mortgage interest rate is based on the prime rate set by the Bank of Canada. Your mortgage interest rate will fluctuate as prime goes up and down. If interest rates go down, more of your payment goes to principal, and if interest rates go up, more of the payment goes toward the interest. You can typically choose a term of three to five years for a variable-rate mortgage. The advantage of a variable-rate mortgage is that you're likely to pay less interest over the long term than with a fixed rate. Oft-quoted mortgage expert Moshe Milevsky, associate professor of finance at the Schulich School of Business, has issued several reports showing that homeowners really do pay extra for fixed-rate mortgages over the long run.
The hybrid or combination mortgage is designed to be a middle ground, targeted to those of us who can't decide whether to go fixed or variable. They were first introduced in Canada in the mid-1990s, but availability was limited until the past few years. This mortgage product allows borrowers to lock in a portion (often half, although not necessarily) of their mortgage at a higher fixed rate and a portion at the lower variable rate. When the prime rate goes up, the fixed portion of your mortgage will insulate you from the impact. Conversely, when the prime rate goes down, the variable portion of your mortgage will cost less and offset the higher costs of the fixed portion.
Most of us cannot accurately predict the trajectory of interest rates over the course of a few months, let alone years, so it seems to make sense to keep a portion of your debt floating while taking some comfort in the fixed portion.
Still, some borrowers and mortgage professionals have concerns about the benefits of the hybrid mortgage to the average consumer.
Steve Garganis, a Toronto-based mortgage broker with Mortgage Now believes that hybrid mortgages are "the worst product a borrower could choose."
Mr. Garganis sees two main issues with this kind of mortgage. First, he has found that hybrid mortgages are not transferable between financial institutions. Second, if the maturities of the fixed rate and the variable rate portions are staggered, you can face a penalty when you want to end the loan or take it elsewhere. Because of these complexities, Mr. Garganis knows several hybrid mortgage consumers who have had little leverage with the bank when it comes time to renew and negotiate.
"There's no one size fits all; everyone has different needs," says Mr. Garganis, who recognizes that some borrowers have a need for the predictability of a fixed-rate loan. Still, he insists that there is no data to suggest that the hybrid mortgage product will save borrowers money and that it is "nothing more than the banks playing off the fear of the average Canadian."
What is clear is that all mortgages are not created equal and borrowers need to investigate and read the fine print before committing to one. Angel VanDamme, director, home equity financing products at RBC, cautions that mortgage terms and restrictions vary from bank to bank. The RBC combination mortgage product offers a high degree of flexibility, Ms. VanDamme says, and is transferable to another institution. While most clients choose to combine five-year fixed and five-year variable-rate terms, some actually prefer to ladder maturity dates in order to take advantage of a lower rate environment.
As an alternative to the hybrid mortgage, several readers suggested using a home equity line of credit, which has an interest rate tied to prime. With this method, you would still carry a mortgage in a fixed-rate product, but finance a portion of your home through a line of credit to get the benefit of a lower, floating rate. This way, you can maintain some diversity in what is likely your largest debt load, while avoiding some of the strings that may be attached to your bank's hybrid mortgage product.