This recent article in the Financial Post prompted me to do some mathematics and put together the following data.
Are you long-term thinker, do you crave stability, nervous about where interest rates may go and when…
To some extent this describes all of us. However locking down one variable in the equation of home ownership (i.e. your mortgage rate for a specific number of years) can create significant exposure to other variables in your life. Employment, health, marriage, divorce, job loss, job promotions, job transfers, making a move, accessing equity, tax planning, and several other things can all conspire to make a long term fixed rate mortgage seem like a major miscalculation.
Indeed lender statistics indicate that approximately 60% of five-year fixed rate mortgages are broken at an average of 38 months. Often this triggers a significant penalty, either outright or via a blended rate, that can amount to a charge equivalent to 3% – 5% of the mortgage balance.
The motivation to choose a 10 year fixed rate is to gain the security of knowing what next months payment is for the next 120 months, however you are giving up a cash premium for said security. Similar to an insurance premium to hedge against future rate increases. I suspect that few people do the actual math on where exactly the break-even point is for the future renewal rates.
Let’s take care of the basic math right up front;
if you lock into a 3.69% 10 year fixed rate mortgage today as opposed to the following available rates (with mainstream national lenders) in the first column, then you must be highly confident that interest rates will be higher than the rate in the second column.
(for purposes of consistency the calculations below were arrived at using equal payments)
term rate today Break-even rate at renewal
3yr 2.65% 4.327%
4yr 2.79% 4.553%
5yr 2.89% 4.85%
Looking at the numbers above; the first question you have to answer in the case of a five-year fixed example is whether or not you believe that five-year fixed interest rates will be at 4.85% or higher five years from now. Once again I must stress there are other considerations beyond this initial calculation.
The above table is over-simplistic to be the sole basis for making a decision. The math that also needs to be done is what happens if you make that 10 year fixed payment while taking the shorter term with the lower interest rate. The key thing that happens is that the additional monies go straight to the outstanding principal balance thus reducing your mortgage balance faster, and ultimately reducing the gross interest paid on the debt.
Here’s what those numbers look like;
Mortgage AM term/rate monthly payment interest paid remaining balance
$500,000 25yr 10yr/3.69% $2,546.76 $52,896.83 $461,213.47
$ 500,000 25yr 3yr/2.65% $2546.76 $37,477.13 $445,793.77
Net Difference $15,419.70 interest saved and instead applied directly to principle.
Mortgage AM term/rate monthly payment interest paid remaining balance
$500,000 25yr 10yr/3.69% $2,546.76 $69,554.42 $447,309.94
$ 500,000 25yr 4yr/2.79% $2546.76 $51,719.52 $429,475.04
Net Difference $17,834.90 interest saved and instead applied directly to principle.
Mortgage AM term/rate monthly payment interest paid remaining balance
$500,000 25yr 10yr/3.69% $2,546.76 $85,694.24 $432,888.64
$ 500,000 25yr 5yr/2.89% $2546.76 $65,825.36 $413,019.76
Net Difference $19,868.88 interest saved and instead applied directly to principle.
When I look at the three tables above I see the opportunity to attain another kind of security. The security of a $17,834.90 lower mortgage balance four years from now for instance.
With a lower mortgage balance I am further insulated from the impact of potentially higher interest rates at renewal time.
Couple that lower balance with flexibility to increase or decrease my mortgage amount in a simpler and less costly fashion, more easily move to another property, or perhaps to a new type of mortgage product and personally I will choose shorter term fixed rates or variable rate the majority of the time for the majority of my properties.
Ultimately each client is best served by sharing their thoughts on this topic with their mortgage broker and going over as many potential scenarios and variables as possible prior to locking in to a long-term commitment which may limit options moving forward.
Thank you for your time.
Dustan