The Hidden Costs of Popular Mortgages

by Robert McLister

For most people, shopping for a mortgage entails reading a few articles, scanning the Internet for good deals, and then putting one's faith in a banker or broker. That's often enough to get the job done, assuming you're working with a good mortgage professional.

If, on the other hand, you're more of a do-it-yourselfer, or you're not sure how competent your advisor actually is, then knowing a few key numbers can come in handy.

At a minimum, do your best to:

• Understand how interest rates have performed in the past
• Know how rates are expected to perform in the future
• Understand how rate hikes affect the total interest you pay
• Realize that rates are generally random (And therefore, planning for potential interest rate scenarios works better than predicting interest rates)

Knowing the above helps you do two things:

• assess your ability to cope with different mortgage rate increases; and
• pick the mortgage term with the highest probability of saving the most money.

To illustrate how the numbers come into play, we'll look at four popular mortgage terms: the venerable five-year fixed, the conservative 10-year fixed, the open mortgage, and the full-featured mortgage with big pre-payment privileges. We'll examine why people pick these terms and how statistics impact each term's total cost of ownership.

The Five-Year Fixed Mortgage

Why People Choose It: 65% of Canadians choose fixed rate mortgages. Most do it because they fear big increases in variable payments. Others choose fixed rates because salespeople push them, or because they don't understand the alternatives.

The Numbers:

• The most prominent research suggests that variable rates save more interest than five-year fixed rates 77% to 90% of the time.
• Variable rates have averaged over one percentage point less than five-year fixed rates for the last 10 years.
• Discounted variables are currently over 2.5 percentage points below five-year fixed rates. That's the biggest fixed-variable spread in over 30 years!
• Looking at past rate cycles back to 1991, prime rate has risen an average of 3.16% from trough to its peak. (1991 is a good reference point because that's when the Bank of Canada started inflation targeting. In turn, 1991 was the start of a major drop in long-term interest rates.)
• Prime rate has averaged 4.81% in the last 10 years, and 5.85% since 1991. Prime rate would have to increase 2.56%-3.60% in order to return to its long-term average. As of writing, prime rate currently stands at 2.25%.
• The big banks predict a 2.92 percentage point increase in prime rate by year-end 2011.
• As you can see above, 3% (give or take) seems to be a reoccurring number when it comes to rate hike estimates. 

Suppose for a moment that prime rate did, in fact, jump three percentage points in the next 24 months (0.25 per Bank of Canada meeting). And suppose that it remained that high for three more years. In that scenario, taking a variable rate of prime - .50% today would still cost you less over five years than choosing a five-year fixed mortgage.

Of course, if inflation exceeds expectations, the Bank of Canada could raise rates more than 3%. The most extreme rate forecasts we've seen is a four percentage point increase (i.e. a 6.25% prime rate). A four point hike would cause variable payments to leap up 50%. In other words, for every $100,000 of mortgage, payments would jump about $214 a month.

Best Bet: History and economist projections are far from infallible, but mortgages are an odds game. The odds suggest variables are still a solid play for the right type of borrower. If you have steady income, reasonable debts, over 10% home equity, liquid savings to cover 3-6 months of living expenses, and you can handle a potential 50% payment increase, then a variable rate is a good bet. For most well-qualified borrowers, it pays to at least consider a hybrid mortgage (part fixed and part variable).

The 10-year Fixed Mortgage

Why People Choose It: 22% of Canadians choose terms over five years, according to the Canadian Association of Accredited Mortgage Professionals (CAAMP). People generally take 10-year terms when they fear abnormal increases in long-term interest rates.

The Numbers:

• 10-year terms cost about one percentage point more than five-year terms, as of this writing.
• Our own in-house research has found 10-year terms to be cheaper in only one out of 10 rolling 10-year periods, dating back to 1967 (the earliest that five-year data is readily available).
• For a 10-year term to be cheaper, five-year fixed rates would have to be over three percentage points higher at renewal in five years (assuming equal monthly payments for the first five years). Keep one thing in mind. If, for example, rates soar in year four or six, that means nothing. When comparing a five-year to a 10-year, all that matters is what the rate is when you come up for renewal in five years.
• For five-year fixed rates to rise three percentage points, five-year bond yields (which guide fixed pricing) would likely have to rise three percentage points as well. That kind of jump far exceeds any major economist forecast.
• Since 1991, five year posted rates have never risen more than 1.35 percentage points at renewal.

Best bet: Go with the odds and stick with five-year terms or less, except if: 1) You cannot afford payments at rates above today's 10-year terms; or, 2) Your tea leaves are calling for a dramatic and unforecasted explosion in long-term interest rates (just be sure you have reliable tea leaves).

The Open Mortgage

Why People Choose It: A relatively small number of Canadians choose open mortgages. The number would be greater if it weren't for open mortgage rates being so darned high. People usually take open terms when they expect to renegotiate or pay off more than 20-25% of their principal within a year.

The Numbers:

• Open variable rates are currently one percentage point higher than closed variables. (Open fixed mortgages are too expensive so we'll ignore them.)
• Based on current rates, open variables become more costly than closed variables after a nine month holding period. In other words, staying in an open variable more than nine months would cost more than if you took a closed variable and paid the standard three-month interest penalty to ?break? it early.

Best Bet: People love that open mortgages have no penalties, but this privilege comes at a price. Unless you plan to break your mortgage within nine months, take a closed variable instead of an open.

A Mortgage with Big Pre-Payment Privileges

Why People Choose It: People relish the thought of pre-paying their mortgage in large chucks without penalty. Even if they don't need them, people often ask for the biggest pre-payment privileges possible.

The Numbers:

• Only 13% of Canadians make lump-sum pre-payments according to CAAMP.
• Those who made lump-sum pre-payments in the last 12 months pre-paid just 1% of their mortgage principal on average. (In dollar terms, that's $1,380 of lump sum pre-payments based on the average mortgage balance.)
• You can often save at least 2/10ths of a percent by choosing a ?no-frills? mortgage. The best no-frills mortgages have just 5% pre-payment privileges (instead of the 10-20% found in most full-featured mortgages).
• A 2/10% interest savings on a $200,000 mortgage can save you over $1,900 in 60 months. Plus, you can still make lump-sum pre-payments of $10,000 (5%) per year.

Best bet: Unless you plan to break your mortgage early or pre-pay more than five percent a year (e.g. $10,000 on a $200,000 mortgage), a no-frills mortgage can be a money saver. Just make sure you understand all the limitations of a no-frills mortgage (many are fully closed for five years or have higher penalties).

The old saying goes: ?The best rate will save you hundreds, but the wrong term can cost you thousands.? With rates near zero and about to rise, proper term selection has never been more important.

Note: The above scenarios and results are approximate and based on various assumptions. All calculations assume a 25-year amortization and deeply discounted interest rates. Variable rate scenarios assume the Bank of Canada will increase rates roughly 3.00% by year-end 2011 (as roughly predicted by the Big 5 Canadian banks). The borrower is assumed to make the same payments for each term being compared, with the payments based on the higher rate mortgage. All results are hypothetical. Actual results may be more or less favourable then indicated here. As always, get professional advice specific to your personal circumstances before making any mortgage decision.

Robert McLister is Editor of CanadianMortgageTrends.com and one of Canada's foremost mortgage authorities. Robert can be reached at robert@canadianmortgagetrends.com.