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(Roberto Marinello/copyright roberto marinello)
(Roberto Marinello/copyright roberto marinello)

Decoding the mortgage market

Mortgages: Nail the right term length the first time Add to ...

Canadian Mortgage Trends editor Robert McLister kicks off his first in a weekly series of columns for the month for The Globe's Home Buying site with this look on the best - and worst - mortgages terms out there.

Finding a good mortgage rate online is a cinch. Anyone who has ever looked for rate comparison sites knows the Internet is packed with them.

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But determining the best mortgage term – the length of the mortgage contract – is trickier because up-to-date term comparisons are hard to find.

Although mortgage terms are often overshadowed by the intense focus on mortgage rates, it pays to put a lot of thought into term selection. It’s the No. 1 factor in determining how much interest you’ll fork over to a lender.

If you pick a closed mortgage with the wrong term, you’re stuck with that rate until maturity, unless you cough up a penalty to break the mortgage. Worse yet, if you choose a “no-frills” mortgage – one with lower rates in exchange for more restrictions – you’re often barred from leaving your lender for the duration of the term, unless you sell the property.

Mortgage terms fall into two groups: Long-term rates, such as four-, five-, seven- or 10-year fixed terms; and short-term rates, which include variable, one-, two- or three-year fixed terms.

Choosing between these terms is not about predicting rates. It’s more about identifying risks and estimating the probabilities of these risks adversely impacting you.

If you are trying to decide which term is best for you, start by making an honest assessment of your financial position and future plans.

A long-term mortgage makes sense if:

  • A 25- to 30-per-cent-plus payment increase would cause you financial stress. (That’s the payment hike that a short-term borrower might face if rates rise as economists project.)
  • Your “emergency fund” covers less than six months of living expenses
  • You have minimal equity and net worth
  • There’s a chance your earnings could drop due to job instability, a highly variable income, upcoming retirement, an educational leave, an extended care leave, etc.
  • You’re heavily invested in long-term fixed income, which creates more risk to your “personal balance sheet” if you’ve also got a short mortgage term and rates surge
  • You want greater certainty when projecting cash flow on an income property

A short-term mortgage may be the way to go if:

  • You expect to pay off large chunks of your mortgage or sell your home within the next three years
  • You have a short remaining amortization (e.g. 5-6 years or less)
  • Your credit is subpar and you need a non-prime mortgage just long enough to rehabilitate your credit so you can qualify with a prime lender
  • You need to refinance in coming years to access your equity for a life event, education, investment purposes, business use, etc
  • You strongly believe that rates won’t rise in any meaningful way over the next 12 months, you can afford to be wrong, you’ve found a short-term rate that’s far lower than long-term rates, and you can make higher-than-required payments.

Let’s suppose you’ve decided a long-term mortgage is right for you. The next question is: Which one?

The answer changes as rates change and at this very minute, it’s almost too close to call. The five-year fixed (currently around 3.24 per cent) and the 10-year fixed (currently 3.89 per cent) are running neck and neck in terms of value.

Assuming you have a 25-year amortization and make payments as if you had a 10-year fixed term, a five-year mortgage will save you $3,259 in the first 60 months, for every $100,000 of mortgage.

By comparison, a 10-year term saves you interest if five-year fixed rates rise more than 1.60 percentage points in five years.

What are the odds of rates climbing 1.60 percentage points? Well, if you believe Bank of Canada warnings and economic forecasts, you shouldn’t bet against it. In the last three interest rate cycles, five-year rates have climbed an average of 2.46 percentage points, albeit for a short time only. So if your financial footing isn’t as stable as you’d like, the 10-year is probably worth the extra “insurance” cost for the peace of mind.

I’ve excluded the comparable math on four- and seven-year mortgages because their pricing simply isn’t good enough at the moment.

If you’ve examined your financial position and found that you’re better suited to a shorter term, the best value currently is a three-year fixed. That is based on the hypothetical assumption that rates will increase moderately starting late this year or early 2013. It also assumes you won’t need to discharge your mortgage early.

You can find three-year mortgages on the street for roughly 2.89 per cent today. This is less than you’d pay with most variable rates and it gives you three years of rate protection.

After three years, you can renew into the best value at the time. You could then choose a variable mortgage, if variable-rate discounts improve – as some people are predicting.

The options laid out above are a glimpse at how a mortgage planner might determine your ideal term. There are, of course, countless other criteria and lots of exceptions.

You’ll find simple mortgage calculators all over the Internet, but there are few good tools to identify the best term. So spend some time researching this and consider bouncing your situation off someone with experience before settling on a strategy.

Robert McLister is the editor of CanadianMortgageTrends.com and a mortgage planner at Mortgage Architects. You can also follow him on twitter at @CdnMortgageNews.

For tips, stories, videos and live chats about what's going on in the real estate market, check out the Globe's Home Buying section for daily updates.

Follow on Twitter: @CdnMortgageNews

 
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