Is a short-term fixed-rate mortgage right for you?
Jordan Lavin
This post was first published on October 31, 2022, and was updated on July 5, 2023.
Mortgage rates have been steadily on the rise over the last year, following one of the fastest Bank of Canada rate hiking cycles in history. With a whopping nine rate increases now in place, the benchmark cost of borrowing has soared from its low of 0.25% – where it was kept throughout the pandemic years – to 4.75% today. In turn, the Prime rate in Canada, which lenders use to set their variable mortgage rate pricing, has risen to 6.95%.
As a result, variable mortgage rates are pretty unattractive right now, with the lowest five-year offering at 5.8%. Unfortunately for borrowers, though, fixed mortgage rate options aren’t providing much of a reprieve; as bond yields have also spiked in recent months, the lowest five-year fixed rate in Canada sits at 4.94%.
But there are some glimmers of hope that lower rates may be on the way, if the economy and inflation keeps softening; some analysts expect the Bank of Canada could even be in a position to start cutting its Overnight Lending Rate by the second half of 2024, if recession indicators indeed come to fruition.
Read: Inflation slows to 3.4% in May, stoking rate-hold hopes
With the potential promise of rate cuts on the horizon, some borrowers are opting for shorter-term fixed rates; locking into a two- or three-year term provides some shelter from short-term volatility in the mortgage market, but also offers the flexibility to take advantage of a the lower interest rate environment that may occur in the near future.
This strategy is an interesting idea in theory – but is it the best way to go in practice? Let’s explore whether a short-term fixed-rate mortgage could be right for you.
What is a short-term fixed-rate mortgage?
While most Canadians sign up for a mortgage that needs to be renewed after five years, shorter terms are available. You can get a fixed-rate mortgage with a term of as little as one year.
Historically, lenders have offered lower rates for shorter mortgage terms because they have more certainty about how much it will cost them to lend you money. The spread between the best 5-year fixed rate and the best 1-year fixed rate has historically been 40 basis points (bps), or 0.40%.
That’s not true at this moment in time, however. Because of recent trends, short-term fixed mortgage rates are currently higher than their 5-year counterparts - as of July 5, 2023, the lowest 3-year term sits at 5.64%, while the lowest 2-year fixed mortgage rate is 6.14%.
Why would I want a short-term fixed-rate mortgage?
Skyrocketing inflation is putting upward pressure on interest rates, which is making mortgages more expensive.While the best 5-year fixed mortgage rate in Canada was 4.14% this time last year, today’s best rate is 4.94% - a difference of 80 basis points.
With much uncertainty about what’s to come for the economy, you may want to buy some time before committing to a longer-term mortgage. A short-term mortgage could keep your rate and payment the same for a year or two, at which time you might have better information with which to make a decision.
If you believe that rates will come back down, you might not want to lock into a longer term. A short-term mortgage would afford you the opportunity to take advantage of lower interest rates when it’s time to renew.
Will I save money with a short-term fixed-rate mortgage?
The answer to this question depends on whether interest rates are likely to fall dramatically over the next year. If they do, you could potentially save money by taking a short-term fixed-rate mortgage now and committing to a better rate at the end of your term.
To estimate whether you’ll save money over the course of five years, compare the total cost of a 5-year fixed-rate mortgage with the total cost of a short-term fixed-rate mortgage, plus the estimated cost over the following years.
Let’s look at an example using Ratehub’s mortgage payment calculator. A $500,000 mortgage with a 5% down payment amortized over 25 years with today’s best 5-year fixed rate of 4.94% will require a monthly payment of $2,856 and cost $114,190 in interest over the 5-year term.
The same mortgage with today’s best 2-year fixed rate of 6.14% would require a monthly payment of$3,202 and cost $28,591 in interest over the 2-year term.
|
|
Rate |
Payment |
Total first year payment |
|
5-year fixed |
4.94% |
$2,856 |
$34,275 |
|
2-year fixed |
6.14% |
$3,202 |
$38,422 |
With a higher interest rate, a 2-year fixed-rate mortgage will require higher monthly payments than its 5-year counterpart.
Assuming your primary goal is to reduce your monthly payment, you’ll need to make up for this difference over the three years following your initial 2-year short-term mortgage. To get even a slightly lower average payment over five years, you would need to get a 3-year mortgage rate of 4.00%* or better when your short-term mortgage is up for renewal. It's important to note that there are currently no short-term fixed-rate mortgages available at anywhere near that rate available in the market, so this is not even an option for the foreseeable future.
*The average monthly payment on a 5-year fixed-rate mortgage at 4.94% is roughly equal to that of a 2-year fixed-rate mortgage at 6.14% followed by a 3-year fixed-rate mortgage at 4.00%.
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Are mortgage rates likely to fall over the next year?
It’s unlikely that fixed mortgage rates will fall at all over the next 12 months, let alone fall low enough to make this gambit worthwhile.
According to Ratehub’s chart of historical mortgage rates, it would be an anomaly for rates to fall more than 1% over a 12-month period. While rapid swings were more common during the market volatility of the 1980s and 90s, a drop of that size hasn’t happened since the Great Recession of 2008-09.
A much more likely scenario is that mortgage rates will continue rising at least through next year. Fixed mortgage rates are primarily influenced by bond yields which, if current trends continue, are projected to rise from their current position of 3.828% to 4.395% by the end of 2023.
That would put 5-year fixed mortgage rates somewhere in the neighbourhood of 6% at that time. If this scenario comes to pass, taking a short-term fixed-rate mortgage rate today only to renew at a much higher rate in 2023 or 2024 could end up making your average monthly payment substantially higher over a 5-year period.
What does all this mean for what mortgage term I should choose?
While rates are rising, it’s probably best to lock in a fixed mortgage rate for a full 5-year term. A 5-year fixed-rate term will give you lots of time to pay down your mortgage balance and help shield you from rate volatility while this latest economic crisis plays out.
It’s also worth noting that it’s much more affordable to break a fixed mortgage when rates are rising. That’s because the formula used to calculate your penalty (the interest rate differential, or IRD) describes how much money the lender theoretically stands to lose. In times of rising rates, your lender is less likely to lose money if you break your mortgage, so the penalty for doing so is therefore much lower.
What can I do to save money on my mortgage?
Without a crystal ball to see the future, it’s impossible to know how mortgage rates will change. Instead of trying to game the system, if your appetite for risk is low, choose a mortgage that will give you a predictable payment and protect you from economic volatility.
If rising rates are making it difficult to afford your mortgage payments, your lender or mortgage broker may be able to help. They’ll be able to give you a better sense of your options and how you might be able to lower your monthly payments – or at least stop them from rising.
The bottom line
While mortgage rates are likely to continue rising, or even remain steady, a short-term fixed-rate mortgage is unlikely to help you save any money. Rates would have to fall significantly for this strategy to pay off, and you could end up paying substantially more over the long run if rates continue to rise the way they are.
If you are risk-averse and worried about today's rising rate environment, choose a 5-year fixed-rate mortgage that will keep your payment predictable for the longest reasonable timeframe for the best results. Be sure to compare mortgage rates online and work with a mortgage broker to find the best mortgage rate to lock in.