Fixed or variable? Long or short? Whether you’re a buying your first home or renewing your mortgage, finding the right mortgage term can be a difficult decision.
The majority of homeowners opt for a five-year fixed term as protection against future interest rate hikes. However, you’ll pay a premium for that peace of mind, both in terms of higher rates and stiffer penalties to break your mortgage.
If you’re looking to save money on your mortgage, nine times out of 10 you’re better off with a variable rate. Going variable used to get you big discounts, as much as prime minus 0.80%.
But times have changed, and those discounts have all but disappeared. Robert McLister, editor of Canadian Mortgage Trends, says one-year fixed rates are now below floating rates.
Whereas the best variable rate is currently 2.65%, a one-year fixed term can be had for 2.39% or better.
“That makes them a solid variable rate substitute, especially since one-year rates move with variable rates 93% of the time,” says McLister.
Advantages of a One-Year Fixed Term
At today’s rates, you’ll save nearly $700 per $100,000 of mortgage in the first year with a one-year fixed term versus a five-year fixed term.
So, if you’re looking for a mortgage today, a one-year fixed term might be right for you. Here’s why:
You’ll get more flexibility because you renew your mortgage in 12 months instead of in three to five years.
At that time you can renew into another one-year term, lock-in to a longer-term fixed or take a variable at presumably a better discount than today.
In a rising interest rate environment, the rate on a one-year mortgage increases slower than a variable rate.
You can lock-in your renewal rate in just six to nine months – you don’t have to wait a year.
One-year fixed terms are also smart for people with short amortizations. That’s because potential rate increases at renewal won’t affect you as much since your payments are mostly principal.
Disadvantages of a One-Year Fixed Term
So why don’t more homeowners choose a one-year term? According to the Canadian Association of Accredited Mortgage Professionals, just one in 16 borrowers take a one-year fixed.
That’s partly because people don’t want the headache of renegotiating every 12 months and partly because variable rates have typically been better.
There are other disadvantages to going short with your mortgage.
Lenders usually pay your switching costs when you choose a longer term mortgage (three to 10 years).
By contrast, when you move to another lender and select a one or two-year term, lenders often won’t pay your switching costs.
A one-year term can leave you exposed if rates jump, so you’ll need to be well-qualified and open to risk, or have only short-term financing needs.
Well qualified means having good credit, reasonable debt ratios, provable stable income and ample emergency savings or equity.
Related: How Much House Can I Afford?
It’s harder to qualify for a one-year fixed term. With a five-year fixed, you’ll have to prove you can make payments at today’s rates (2.99% – 3.09%).
But if you’re getting a one-year fixed term, most lenders want to ensure you can afford the five-year posted rate – which is currently 5.24%.
That rules out many first time home buyers, who generally have much less equity, net worth, job stability and ability to withstand 20 to 30% payment increases. They’re usually better suited to longer terms.
Fortunately, the rate differential between long and short terms is exceptionally reasonable today. For just 0.6% more than a one-year fixed, homeowners can guard against interest rate hikes for five full years.
McLister points out that anyone choosing a one-year fixed term should consider setting their payments based on a rate that’s 2% higher.
“That way you’ll have minimal payment shock if and when rates climb. You’ll also chip away big chunks of principal,” says McLister.
That’s exactly what we did when we bought our house last summer. We went variable, since the discount was prime minus 0.8%, but we set our payments based on a 5% rate.
Related: Our Fast Track To Financial Freedom
The economic outlook remains bleak, so interest rates won’t likely be rising any time soon.
Variable rate aficionados should consider a one-year fixed term; at least as a temporary measure, until we see those big discounts on variable rates come back.