The best rate will save you hundreds, but the wrong term can cost you thousands
Our friend and mortgage expert John Shearer is advising Ratehub.ca readers this week on the feasibility of the rarely elected 10-year mortgage.
Too often borrowers are concerned with getting the lowest mortgage rate, not realizing locking in to the wrong term can be significantly more expensive.
Although it does not happen often, every once in awhile, a customer will inquire about a 10-year term. Record low interest rates and the inevitability of rate increases have drawn some customers to longer terms as of late.
The 10-year mortgage allows maximum risk aversion, and the knowledge your mortgage payments will not change over the course of a decade. This kind of security comes at a price, however.
Mortgage rates are priced on the risk posed to the lender. So, simply put, the longer you lock in the security of a set interest rate, the more you will have to pay the lender.
Anecdotal evidence suggests a 10-year term has historically been offered at a typical premium of 1.25% more than the 5-year term, which is the most popular mortgage term in Canada.
You may be willing to pay a premium for future protection, but let’s look at how much that extra security will cost you in the short term and also how many times the added security has paid off in the last 25 years.
For the purpose of the following examples, let’s use a premium of 1.00% on the 10-year mortgage compared to the 5-year mortgage. This simplifies our discussion as well as provides a conservative outcome.
(Note: A recent synopsis of lenders’ rate sheets indicate 1.00% as the average difference between 5- and 10-year terms)
Is paying the premium for a 10-year mortgage worth it? We can assess the short-term cost of opting for a 10-year term by comparing it against two consecutive 5-year terms over the same period.
Let’s say we have a 5-year fixed mortgage at 4.00% and the 10-year fixed mortgage is 5.00%. For every $100,000 of mortgage, you will pay an additional $4,788 in interest over the first five years of the 10-year term.
Assuming your first 5-year term with an interest rate of 4.00% is amortized over 25 years, the rate on your second 5-year term would need to increase by roughly 2.25% in order for the interest paid over the two terms to equal the interest outlay on the 10-year mortgage.
Make sense? Let`s look at the numbers.
- The total interest paid over 10 years at 5.00% would be $43,588.
- A 5-year fixed rate at 4.00% would equate to $18,615 in interest over the first five years.
- For the 10-year term to make sense financially, a new corresponding 5-year mortgage would need to cost more than $24,973 in interest over the final five years, at a rate of around 6.25%.
So, you can see you pay a considerable premium going in to a 10-year mortgage, on the assumption interest rates will climb considerably in the near future.
How many times in the past 25 years has the 10-year rate proven more affordable than two consecutive 5-year rates? Let`s consult the Bank of Canada records.
Compiling the average 5-year fixed rates for the last 25 years from the Bank of Canada and adding a 1.00% premium, we can determine estimated 10-year interest rates. Then, we are able to conclude if the 10-year rate is higher or lower than a corresponding 5-year renewal rate.
Here’s an example:
- In January 2000, the average rate on a 5-year fixed mortgage was 8.55%
- We can estimate the interest rate on a 10-year mortgage in January 2000 would be 9.55%
- If we look ahead five years, we can see what corresponding 5-year fixed renewal rate is available, and compare it to the January 2000 10-year rate
- According to the Bank of Canada, in January 2005 the average 5-year interest rate was 6.05%
So, the interest rate premium paid on the 10-year mortgage for protection against future rate hikes not only is unnecessary, but in the example above, interest rates actually decreased over the first five years of the mortgage term.
Extrapolated over a longer period of time, we get an idea of how often the safety of the 10-year rate will pay off.
In fact, in the 300 months under review, the 10-year rate was lower than the corresponding 5-year renewal rate only eight times.
It is important to note as well that in NONE of these eight instances was the difference between rates large enough to create a positive outcome by opting for the 10-year mortgage.
While this illustration is by no means a scientific study, it does show how infrequently a 10-year rate beats two consecutive 5-year rates.
Being in a low interest rate environment, it begs the questions, is this one of the three times out of 100 that a 10-year mortgage will come out on top?
*Note that under the Interest Act you can break a 10-year mortgage with a penalty of only three months interest, after five years, as opposed to the often higher Interest Rate Differential (IRD) penalty that normally applies. However, why pay the premium in the first five years?