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Avoid the 5-Year Fixed Mortgage Trap


Should I go short or long; fixed or variable with my mortgage?

“I wish I had an answer to that, because I’m tired of answering that question.” – Yogi Berra

Number 3 on our list of things on which Canadians waste the most money is 5-year fixed mortgages.

They are marketed as being safe and a good protection against a sharp rise in interest rates. The reality, though, is that they are nearly always a huge waste money, they limit your flexibility and result in losing your negotiating power for 5 long years.

That is why we call it the “5-Year Fixed Mortgage Trap”.

I am not a mortgage broker, but have researched mortgages and always have strong opinions. The most common questions about mortgages are “short vs. long” and “variable vs. fixed”. Which is better? Canadians often debate this, but studies consistently show that short beats long and variable beats long term fixed.

If it is so obvious, then why doesn’t everyone see it? Longer term mortgages are marketed heavily by banks and mortgage brokers that make far more money on them then short term mortgages. Also, most people are bad at math and may get a general feeling of security from a fixed rate, but they do not do the math on how much this protection costs or the odds that they will lose money.

“Unfortunately, most of the existing folklore and advice is rarely subjected to formal statistical analysis and does not address the probability that a given strategy will be successful.” (Moshe Milevsky) The main reasons commonly used for taking 5-year fixed mortgages turn out to essentially be myths:

3 Mortgage myths about 5-year fixed mortgages:

1. They are safer

A study by Moshe Milevsky, finance professor at York University, from 1950-2000 showed that the average Canadian wastes $22,000 after tax (based on a $100,000 mortgage for 15 years) in their life because they got sucked into 5-year fixed mortgages rather than variable.

If your mortgage started at $300,000, then you can expect to waste $66,000. They also took on average 38 months longer to pay off their mortgage. The chance of losing money over 5 years was 89%. A study by Peter Draper (mortgage broker) comparing 5-year vs. 1-year mortgages from 1975-2005 showed that the 1-year mortgage saved money 100% of the time! How can an 89-100% chance of losing thousands of dollars be safer?

2. Rates may go very high like in the 1980s

I was an accountant for a mortgage company in 1982 when mortgage rates peaked at 22.75%. My first mortgage was a 5-year fixed in 1980 at 13.75%. I thought that I had lucked out, since rates jumped to 22.75% and were back to 13.75% by 1985 when it came due. What I didn’t realize was that, even then, I would have saved money by going variable! Based on Peter Draper’s study, I would have lost money for 2 years and saved money for 3 years. So, even with a huge leap of 9% in mortgage rates in the first 2 years of my mortgage, I still lost money with a 5-year fixed rate!

Also, the odds of a huge rate rise are extremely low. We can’t calculate them, since it has only ever happened in the early 1980s, but the odds must be extremely low. Demographers, like Harry Dent, claim it related to Baby Boomers entering the housing market for the first time, which is a phenomenon we don’t expect to be repeated in the next few decades.

3. Your mortgage payments will stay the same

Most variable mortgages also keep your mortgage payment the same during the term. Many people believe that their mortgage payment will fluctuate with a variable mortgage, but this is also a myth.

Top 4 reasons to stick to short or variable mortgages:

1. Save thousands

On average, you should save 22% of the starting amount of your mortgage and pay it off 38 months earlier. (Moshe Milevsky) In the Toronto area, an average mortgage is $2-300,000, which would be savings of $44-66,000 after tax. That is essentially one full year’s earnings, so the average person works one extra full year just to pay the money wasted by taking 5-year fixed mortgages!

2. Low risk

With variable mortgages, the chance of saving money is 89-100%. Yes, the variable is the low risk!

3. Flexibility

Many things can happen in your life in 5 years that may make it advantageous to refinance. You may want to move, roll in other debt to get the lower rate, make extra payments with no limit or change some terms. Our experience with our clients is that most do some sort of refinancing every couple of years, so being locked in for 5 years is a long time.

4. Negotiating power

The mortgage market is very competitive, so every time your mortgage comes due, you have lots of negotiating power. You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service. During the term, you have hardly any power. Remember that when you sign a 5-year mortgage, you sign away your negotiating power for 5 years!

The main reason that 5-year fixed mortgages lose money vs. 1-year is that, in a normal market, they start about 2.5% higher. If you pay 2.5% more in year 1, you need the average for years 2-5 to be more than 3% higher than today’s rate. To be ahead, rates would have to jump by more than 3% and stay there for the next 4 years – a very unlikely scenario.

Conclusions:

  1. Stick to 1-year fixed or variable mortgages. Usually, you should take whichever is lower, but only take variable at a good discount, such as prime -.8-.9%.
  2. Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more, plus you will have lost your flexibility and negotiating power for 5 years. Remember that even when rates leaped 9% in 2 years from 1980-82, short term rates still saved money.
  3. Never take a mortgage term longer than you expect to stay in your current home.

We have been referring people to mortgage providers since the mid-90s and most today have rates below 2%. Most of our clients still have the prime -.85% rate that we had for years before this recent crisis or have our recent 1-year rate of 1.99%.

Today, we are recommending 1-year fixed, not variable. The best variable rates are prime -.4-.6%, but rates are normalizing quickly. We expect that the prime -.85% (or lower) rates will be back soon. We expect that anyone taking a variable today will regret having locked in before the larger discount is available.

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.  If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com.  You can read his other articles here.

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About the author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.

{ 210 comments… add one }

  • brian June 5, 2012, 10:15 pm

    Hi Ed,

    Just wondering if your take on things has changed at all lately? I have just been quoted by my bank 3.19% for a 5 year fixed,and the best current 1 year seems to be 2.64% for a difference of .55%

    We are looking at an approx $350k MTG.

    I have been burned before on a 5 year,and payed a $20k penalty,so I am very interested in your comments. Our plans are to stay in this house for the next 5 years,and we will likely take a HELOC.

    We are buying under market value privately,and would like the ability to access the increased equity down the road for a DP on a rental property.

  • Ray December 7, 2012, 3:58 am

    This has been an interesting read from beginning to end.

    Hopefully Ed can comment on the above comment. I am entering into my first mortgage and was able to negotiate at 5yr fixed rate of 3.09% but also have the option for a 3yr fixed at 2.79%.

    I am not seeing the low rate for 1yr fixed or variable rate mortgages.

    What would you suggest is the best coarse of action is?

  • Dk January 29, 2013, 11:05 pm

    Hey there

    I am up for renewal and was previously on a 5 year variable (PRIME -.75 and most recently my rate was 2.25)

    I am up for renewal in February and was given rates and thinking
    fixed 2 year rate was 2.44
    3 year rate 2.88 or
    5 year rate of 3,04. (Most likley not going for this. )

    Advice?

  • Rob April 5, 2014, 7:51 pm

    Any updates on the current recommended strategy? I’m up for renewal in 6 months!

  • Brian Poncelet,CFP April 6, 2014, 10:30 am

    Rob,

    I am not a mortgage broker, but I have said to my clients for about 20 years that interest rates are not really going anywhere.

    The variable route is the best. If you are really concerned is split it. Half variable the other half fixed.

    I still don’t like the five year terms…but at 2.9% it’s not bad.

    Just my thought.

    Brian

  • Ed Rempel April 6, 2014, 7:24 pm

    Hi Rob,

    The 5-year fixed has never worked and is unlikely to work now, as well. I think the best option today is the 2-year fixed at 2.59%.

    The 5-year fixed of 2.99% being offered today has very restrictive terms. If you take the 2-year, you save .4% for the first 2 years. It would have to average higher than 3.26% in the last 3 years for the 5-year to save money, which is a rise of .67%. It’s very hard to predict interest rates, but I think a rate increase that large is unlikely. At this point, the Bank of Canada is still talking about rates staying low at least 2 years.

    The variable rate is tempting and lower than the 2-year fixed now, but we’ve been holding out for the larger discounts from prime. For years, we were getting prime -.85% or even better. I think those discounts are still likely to return once rates rise a bit, so I would hesitate to lock into a 5-year variable.

    Even if I thought rates may rise enough so that the 5-year fixed might save a bit of money, staying shorter keeps you flexible and able to refinance. I’ve seen way too many people pay large penalties to get out of 5-year mortgages, fixed and variable, to think of them as the “safe” option.

    Ed

  • Rob May 28, 2014, 9:35 pm

    Ed, thanks for the reply! Embarrassingly, I completely forgot about this post until now. But my own research came to the same conclusion of the 2-year fixed at 2.59% so, I’m glad I’m on the same page as you. I also want to do smith manouevre once I move to more permanent home in a few years, so only locking in for 2 years is ideal. When I’m ready to do the smith manouevre, I’ll be contact your experts :) Other criteria I have for now is lump sum payments and being able to port mortgage penalty-free (if i decide to move). Met with a mortgage broker today who agreed (although she did try to convince me to go 5 year at first). She suggested First National or Street Capital, and was going to do some more reading and set up another meeting.
    Interestingly, she discouraged me from getting a HELOC added as an emergency fund, since she said it can be hard to port those if I were to move (since they are set up separate from the mortgage) .

  • Alpha Centauri July 17, 2014, 1:11 pm

    This is a great article! And from my experience, very accurate. Over the years, I’ve had a combination of mortgages: variable, fixed, and line of credit. The worst by far? You guessed it: The 5-year fixed. And for the exact reasons mentioned here:

    1) When I sold a property, and broke a five-year fixed, I paid about $3000 in mortgage cancellation penalties. And it could have been worse, because the mortgage was modest in size, ie under $100 000.

    2) Interest rates have essentially gone down over the last 10 years, so fixing for 5, has been a raw deal. No wonder this has always been the case since 1950. Some of these mortgages have been for rental properties, and since the interest can be written off as an expense, I’m keenly aware of the added cost for a five-year fixed!

    Now, I use a Home equity line of credit (HELOC). Interest rate is higher at 3.5% (prime +0.5%), but there is no restriction on prepayment. Any immediate income I receive is used to pay down the principal. You pay the mortgage down much faster this way. Plus any larger purchases for business use (eg renovations to rental properties) are put on the HELOC, to write off a portion of the interest. Just be sure to keep the appropriate documentation.

    I also have used short term mortgages. The interest rate is usually similar or better than the 5-year fixed, without all the worries of cancellation penalties. Check to see how much it will cost to cancel a 1-year mortgage early. Likely it won’t be much, because you’ll always be close to the renewal date.

    My last 5-year fixed will expire this December. What will I do? Because I may sell the property with the next few years, HELOC and/or 1-year mortgage!

  • S July 17, 2014, 5:24 pm

    Alpha,
    Get your bank to match RBC’s HELOC rate at prime. The +0.5% is pure gravy that I had my bank reduce on all my HELOCs, otherwise I would have taken all my accounts elsewhere. I went to two other banks who offered prime and were willing to pay all transfer/appraisal costs.

    I use only HELOCs to finance properties and my bank now gives me the max. HELOC on new purchases instead of a mortgage. As you said, pay down is faster, easier and the paperwork is so much simpler than a mortgage since it just involves placing a lien. Purchases are now quick and streamlined.

    One other item worth mentioning is the bargaining power of a HELOC. Even in today’s competitive (sometimes insane) real estate market, a no financing offer with a closing date of whenever the owner wants, still affords me the ability to buy at a lower, more reasonable price. Though it’s much tougher out there than it’s ever been to pull this off, especially when it comes to premium properties that will have multiple rental offers.

  • Graham May 18, 2015, 11:40 am

    Great article. Perhaps I missed it, but how do discharge fees (when switching mortgage lenders at end of term) figure into the equation? Here in Ontario, the norm seems to be in the $200-$400 range. If I’m charged that kind of fee at the end of each term, then the benefit of a shorter term could be cancelled out by these fees.

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