Variable or fixed? Both options have merit

Whether you prefer to go fixed or variable with your mortgage, there are developments you need to know about if you want protection against rising rates and ways to outsmart your bank.

Let's start with fixed-rate mortgages, where we continue to see borrowing costs at close to historic lows. Most people go with a five-year term, but there's a case to be made for choosing terms of seven or even 10 years.

Rubbish, you savvy borrowers are no doubt saying. The premium to lock in for seven years is too high to make it worthwhile.

"There's not a right or wrong choice," replies Peter Majthenyi, a mortgage planner with Mortgage Architects in Toronto. "It's capturing the temperament and risk tolerance of the client."

These days, those of Mr. Majthenyi's customers who prefer a locked-in rate are commonly going with 10-year mortgages at 5.3 per cent. That compares with his best rates of 3.79 per cent for a five-year mortgage and 1.95 per cent for a variable-rate loan.

Some homeowners can't get comfortable with the idea of paying such a large premium to lock in a mortgage for a decade, Mr. Majthenyi said. But there are cases where it makes sense. Example: People who are buying a house in today's hot market and want some cost certainty as they take on a mega-mortgage and look ahead to years of rising rates.

With a 10-year mortgage, you're entirely insulated from the coming cycle of interest rate increases. Over that period, Mr. Majthenyi notes, your income will rise and you'll pay off a lot of the interest on your mortgage. At renewal time, you should be in a good position to make higher mortgage payments if need be.

The 10-year rate of 5.3 per cent seems high in comparison with current five-year rates, but it's reasonably attractive if you look at the past decade. The average five-year rate posted by the big banks over that period was 6.78 per cent, according to Bank of Canada data. If we discount that rate by 1.5 percentage points, we get a real-world average, five-year rate of 5.3 per cent.

There you go: 10 years of rate certainty at the cost of five years' worth over the past decade.

To give the other side of the argument about long-term mortgages, let's hear from mortgage broker Jim Tourloukis of Advent Mortgage Services in Unionville, Ont. He points out that the higher rate for the 10-year mortgage would potentially cost hundreds of dollars more per month.

"That's a big insurance premium to pay," he said. "Peace of mind is important, but you can get that with a five-year mortgage."

Worried that you'll have to renew at much higher rates in five years' time? Mr. Tourloukis said you can work around this by jumping into a one-year mortgage on renewal.

As the economy slipped into recession, we saw short-term mortgage rates at roughly the same level as five-year mortgages. But it's more typical for there to be big savings in a one-year term. These days, for example, Mr. Tourloukis is advertising a one-year rate of 1.99 per cent, and a five-year rate of 3.74 per cent.

Now let's talk strategy for people with variable-rate mortgages, specifically those who took out their loans early in 2009. The financial crisis was still raging back then and lenders were charging the prime rate plus a markup of as much as a full percentage point for variable-rate mortgages.

You can now get a rate of prime minus 0.1 to 0.3 of a percentage point. The net result for some borrowers is that they could chop their rate by a full percentage point if they were to break their current mortgage.

Mr. Tourloukis said it can be cost-effective to do this, thanks to a quirk in mortgage fine print. The penalty for breaking a variable-rate mortgage is three months' interest - period. With fixed-rate mortgages, lenders charge the greater of three months' interest or an "interest rate differential" (IRD) that compensates them for interest lost as a result of you breaking your mortgage.

Lots of people have tried to break existing mortgages and been deterred by astronomically high IRDs. Mr. Tourloukis said it's plausible that someone who took out a $300,000 variable-rate mortgage last May might face a penalty of something like $2,200.

What are the potential savings if you reduce the rate on a $300,000 variable-rate mortgage taken out last spring to current levels? Close to $2,000 per year, assuming you make 26 biweekly payments. With a five-year term, you could be looking at more than $6,000 in cumulative, after-penalty savings if you make your move now.

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Go long?

You'll pay a sizable premium to lock in a mortgage for 10 years, but the rate won't be bad by historical standards and you'll have total cost certainty on your mortgage for a decade. Here's a survey of 10-year rates.