Why a 5 Year Fixed Mortgage May Not Be The Best Choice

There are so many options when trying to choose a mortgage that is best for you. The most common question is whether to choose fixed or variable.  However, one that is less common is regarding the length of your mortgage term.

The 5-year fixed mortgage has become standard, but this doesn’t necessarily mean that this is the best term for you. In the past, shorter-term mortgages typically came at lower rates, so there was often the opportunity to save by choosing a shorter term.  In today’s mortgage world, rates on shorter-term mortgages are usually higher than 5-year terms.

For example, the lowest 5-year fixed mortgage has now dropped to 2.54%. This is for insured mortgages or purchases/switches with 35% or greater equity*. For purchases with 20% down payment, the lowest 5 year fixed is 2.69%. Value of the home must be under $1 million OR home must have been purchased prior to November 30^th, 2016 to qualify for these rates.  For homes valued at over $1 million, or for mortgages with 26-30 year amortization, the lowest 5-year fixed rate is 2.84%. (Note that some exceptions apply).

The lowest 3 year fixed by comparison is 2.79%.  That’s 0.25% higher in some cases! This makes it pretty hard to choose anything but a 5 year fixed. While in the past it took a lot more thought to choose the right term, in today’s mortgage world the 5-year fixed term will make the most sense for most.

When to Choose a Shorter Term

There are still times when it will make sense to pay a higher rate for a shorter term. For example, if you think you will be breaking your mortgage after 3 years, then it may make more sense to go with a shorter term mortgage… even if the rate is a bit higher. Why?

Rate is only one component in the cost of the mortgage. If you think you are going to break early, then you also need to consider the penalty. You would then need to compare the approximate penalty with the savings you would get from the lower 5-year fixed rate.

Let’s say for example you need a $500,000 mortgage amortized over 25 years. You think there is a good chance you will break it after three years since your plans are to upgrade your home. You have the choice of a 3 year fixed at 2.79% or a 5 year fixed at 2.74%.

The savings you would see after three years from the lower rate would be $3,690.93 if choosing the 5-year term at 2.54%. After three years, you would owe approximately $453,000 (assuming monthly payments and no additional payments made). The 3 months interest penalty would be approximately $2,900 + discharge fee of approximately $350 for a total of $3,250. 

Compare The Total Cost of Each Option

Even though the rate is 0.25% apart, the total cost is very close once you consider the penalty. In the case above, I used a three months interest penalty, but your penalty to break could be greater than that. The penalty to break a fixed rate mortgage is always the higher of three months interest or the interest rate differential (IRD). The IRD is the difference between the rate you are paying and the new rate the lender would have to re-lend the money out at. The simplest way to explain it is if the rate at the time you break is higher than what you are paying, then you would pay three months interest. If it’s lower, you would pay the IRD. The calculation is more complex than that, but that’s the basic concept of it.

So if rates are lower at the time you break your mortgage, you’ll certainly be paying a penalty that is higher than 3 months interest, which would then have made the 3-year fixed at the higher rate the more economical option. 

In the example above, I’m using a rate difference of 0.25%, which will not always be the case.  Where the rate difference is minimal, you may want to opt for the slightly higher rate to reduce the term in which you are committed to that mortgage.

Porting Your Mortgage to Avoid Penalty 

You can always port your mortgage over to the new property, which would result in you paying no penalty at all, however, porting your mortgage does not always work out to be the best option. In fact, it usually isn’t unless rates have increased substantially.

Longer Term Mortgages

10 year fixed terms are something that some are considering now as well, however chances of anyone staying in the same mortgage for 10 years is quite remote, and therefore these are not recommended for most.