"… Divide your investments among many places, for you do not know what risks might lie ahead."– Ecclesiastes 11:2
That passage was written before 900 BC. That's how long people have been talking about the benefits of diversification. Yet, three millennia later, 96 per cent of mortgage borrowers still put all of their eggs in one basket. They pick only one term and go with it.
A paltry 4 per cent choose hybrid (a.k.a. combination) mortgages, Mortgage Professionals Canada says. A hybrid mortgage lets you split your borrowing into two or more rates. The most common example is the 50/50 mortgage, in which you put half your mortgage in a fixed rate and half in a variable rate.
Some hybrids let you mix the terms (contract lengths) as well. You might put one-third in a short fixed term, for example, and two-thirds in a long term. With certain lenders, such as Bank of Nova Scotia, National Bank, Royal Bank of Canada, HSBC Bank Canada and many credit unions, you can mix and match rates and terms in almost infinite combinations.
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The point of a hybrid mortgage is to reduce your exposure to unexpected adverse interest-rate movements. If variable rates shoot up and you have half your borrowing in a long-term fixed rate, you'll feel less pain than if you had your entire mortgage in a variable or shorter term. Conversely, if rates drop, you still enjoy part of the benefit.
Hybrid mortgages can fit the bill for folks who:
- Are torn between a fixed and variable rate;
- Think rates should stay low but who can’t bear the thought (or cost) of them soaring;
- Want a lower penalty if they break their mortgage early (big penalties are a common curse of longer-term fixed rates);
- Have a spouse who has the opposite risk tolerance.
So why, then, is only one in 25 borrowers choosing hybrids, a number that hasn't changed much in years?
Well, for one thing, hybrids are misunderstood. They're also insufficiently promoted, entail more closing costs and (often) have uncompetitive rates. But not always.
The costs
One knock against hybrids is that they're more expensive at renewal. They must be refinanced, which usually entails legal fees. By contrast, when you switch lenders with a standard ("non-collateral") mortgage, the new lender usually pays your legal and appraisal costs.
This disadvantage is most applicable to folks with smaller loan sizes. If your mortgage is $200,000 or more, those refinance costs equate to a rate premium of less than a one-10th of a percentage point on a five-year mortgage. That's peanuts for the diversification benefits of a hybrid rate, especially if you can find a lender or broker to cover those refinance costs.
Hybrids to avoid
There's a strategy in bond trading called laddering. That's where you buy multiple bonds with different maturity dates to lower your risk. If rates dive, your long-term bonds will still pay higher interest. If rates soar, your short-term bonds will mature quicker, letting you reinvest in better rates sooner.
Homeowners can ladder, too. One method is to get a combination mortgage and set up five segments: a one-, two-, three-, four- and five-year term. That way, only a portion of your borrowing will mature every year. So you'll never have to renew the entire mortgage balance at unfavourable rates.
That may seem appealing on the surface, but it's really a sucker's play. The problem is, whenever any segment comes up for renewal, the lender has you over a barrel. Lenders aren't charities. They maximize revenue at maturity by evaluating your available options. They know that people with staggered terms have to pay a penalty to leave if they don't like the lender's offer. Those penalties can cost thousands (or tens of thousands). So lenders typically give lacklustre renewal rates to borrowers with differing maturity dates.
Quick perspective: If you have to pay a rate that's even two-10ths of a percentage point higher, that's roughly $1,800 in extra interest over 60 months on a typical $200,000 mortgage.
The best combos
If you're going to go hybrid, match up the terms. For example, pair a five-year fixed with a five-year variable. That way, both portions mature at the same time. Then, if you don't like your lender's renewal quote on one portion, you can fly the coop with no penalties.
And by all means, shop around. The majority of hybrids have junk rates. Look for rates that are within 0.15 percentage points of the market's best, for each segment in the mortgage.
Should you get one?
Virtually no one on Earth can consistently time interest rates. No banker, no broker, no economist, no Bank of Canada governor, not even money managers paid millions. But with hybrids, timing matters less. They take the guesswork out of rate picking.
Granted, if you're a well-qualified, risk-tolerant, financially secure borrower, you're often better off in the lowest-cost standard mortgage you can find. And there's historical research to back that up. But if your budget has less breathing room or rate fluctuations make you slightly queasy, hybrids are worth a look.
Just be sure that your mortgage is big enough, that all portions renew at the same time and that you avoid hybrids with uncompetitive rates on one or more portions.
Robert McLister is a mortgage planner at intelliMortgage and founder of RateSpy.com. You can follow him on Twitter at @RateSpy