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 A Definitive Guide To Short Term Fixed Rate Mortgages

 A Definitive Guide To Short Term Fixed Rate Mortgages

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Many borrowers have recently opted for a short-term mortgage versus the ever-popular 5-year fixed rate mortgage. This blog post explores the reasons behind this shift and if it is suitable for everyone. Picking a short-term has its risk factors, pros and cons, that may make it unsuitable for everyone’s borrowing situation.  


Key Highlights

  • Short-term interest rate mortgages are a good option for hedging rates if you expect rates to fall over the same period.
  • The mortgage term you choose should be the period that aligns with your life goals.
  • If you can accept a 1% risk of increase to your payments, then a variable rate mortgage may be a good option to benefit from immediate savings if the BoC reverses course on its rate hikes.

What is a Short-term Fixed Rate Mortgage?

Short-term rates are 1, 2 or 3-year fixed, or sometimes variable-rate, mortgages available to borrowers. These mortgages are priced on their corresponding shorter-term bond yields issued by the Bank of Canada. 

 As of late, these shorter-term interest rates have been gaining traction. Whereas in the past, most borrowers chose to go with the 5-year fixed rate, now 2-or-3-year terms are outgrowing them. The short-term interest term is also beneficial for lenders – there is enough revenue forecasted for the mortgage to offer deeper discounts towards their profit margins. So this can be a good option for both borrowers and lenders. 

Typically, a shorter-term fixed rate, such as the 1-year, will be priced much lower than the 5-year as lenders can assess their risk versus costs more avidly. Though this premise will often be true, it currently stands untrue due to the surging inflation. 

Why Do Mortgage Borrowers Choose Short-term Fixed Rates?

If there is no stability in a shorter term and the corresponding rate, and it’s currently priced higher than the longer and most popular 5-year fixed mortgage rate, then why would anyone decide to go with a shorter term?  The answer mainly hinges on your belief that the Bank of Canada is doing enough to fight inflation.

Surging inflation is increasing rates, and the uncertainty around the economy puts pressure on homeowners and homebuyers as they wrestle with higher mortgage-carrying costs. With so much uncertainty, even though a higher rate comparatively, a shorter term interest mortgage term still gives you the time to delay locking into a higher rate for a longer period.

If you expect that rates will eventually taper off by the end of next year, as many economists are predicting, then delaying locking into a long-term rate will pay off. Delaying is likely the best solution to hedge costs at this time.  

Many in the mortgage industry believe that BoC’s rate cycle is ending and we are hitting or approaching the upper bound limit of the 5-year fixed rate.  Once inflation is under control, then rates should start heading back down – making locking into a high 5-year fixed rate at this time seem like paying for a product at its highest price.

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Choosing a short-term fixed rate to prepare for an inflation slowdown

You can choose a short-term rate to hedge interest-carrying costs if you believe that the Bank of Canada will do enough to control inflation over the same time.  Currently, nesto’s best 2-year fixed rate is 5.12%, and the 3-year fixed rate is 4.92% – whereas the 5-year fixed rate is currently at 4.89%.

Comparing the carrying costs for a $500,000 mortgage at nesto’s current rates, we calculated that you’d pay about $500 more over your term if you go with a 2-year fixed and about $120 more over your term if you go with a 3-year term compared to the current 5-year term.  

You may say that it is not a lot of savings to go through the trouble of renewing again in 2 or 3 years. That is a valid point, but there is a big possibility that rates could come down more significantly over a 2- or 3-year period, whereas locking into a 5-year fixed would mean you would continue to pay this higher rate and monthly payment until your mortgage term ends.

Term  2-Year Fixed  5-Year Fixed 
Rate 5.12% 4.89%
Monthly Payment  $2943 $2877
Total Interest over 2 years $20,952 $21,620
Based on a $500K mortgage balance over a 25-year amortization using the current posted rates at nesto.ca
Term  3-Year Fixed  5-Year Fixed 
Rate 4.92% 4.89%
Monthly Payment  $2885 $2877
Total Interest over 3 years $33,109 $33,240
Based on a $500K mortgage balance over a 25-year amortization using the current posted rates at nesto.ca

Choosing a short-term fixed rate to prepare for short-term life decisions

A shorter term rate may not always be the best cost-effective motivation. It is altogether possible that your life goals may need a shorter solution.  

Here’s a real-life example of why a short term might be most suitable for your situation:

  • Having a partner on parental leave or sharing up to 18 months of leave with your partner can impact cash flow. Between employment insurance for parental leave and parental leave top-ups by your employer, generally, your after-tax income may still stay consistent. Most lenders will qualify for a mortgage on the full income stated on a return to work employment letter, but these numbers don’t pick up the true impacts on the cash flow of having a child.  
  • A expected change in work or education which requires relocation.
  • A expected change in employment, if switching lenders between terms, may affect total income if bonuses need inclusion in qualifying for a new mortgage.
  • Moving to a new community to be to your partner or aging parents.

 All of these possibilities can certainly add a more realistic reason to go with a short-term rate, as the time horizon of your mortgage term would align with your own life goals. Thus, avoiding having to renegotiate your mortgage during those periods is a more time (and stress) saving option.

Short-term Fixed Rates vs Short-term Variable Rates

A short-term fixed rate provides stability of payment and borrowing cost over a set period of 1 to 3 years.  It will have a penalty if there is a pending need to break it – calculated as the greater of the interest rate differential or 3 months’ worth of interest.

A short-term variable rate is usually available for a 3-year term providing a static (variable rate mortgage) or fluctuating (adjustable) payment and a fluctuating cost of borrowing, which is the interest charges over the mortgage.  But it does give you 2 good reasons to pick it over a fixed-rate option.  

First, immediate interest and monthly savings if rates should fall during your term. Second is the option to break it anytime with a penalty calculated as 3 months worth of interest. Mind you, if rates increase, your 3 months’ interest will increase from the originally agreed rate on the variable mortgage option. However, in this scenario, the short-term fixed rate may become a more cost-effective option as the 3 months interest will be lower if rates do increase. 

Short-term Rates vs 5-Year Rates

Fixed rates are typically chosen for their stability and predictability factor, keeping your mortgage payment and rate static throughout your term. The longer your term, the bigger the chance that you could miss out on interest savings if rates should fall.

Short-term fixed rates should be chosen if their time horizon meets your own time constraints. They are also great for hedging rates if you expect rates to fall at the end of your selected term. There is no indication that rates will settle within the next 12 months – so if you decide to go with a short-term fixed rate option, then you can secure a payment based on 24 or 36 months – to avoid the need to renegotiate during times of economic uncertainty.

Over the years, most homeowners looking to renew their mortgage and homebuyers looking to purchase a home have chosen to go with the 5-year fixed rate. People will choose a 5-year fixed rate as it provides them time to make life changes like pursuing a new employment opportunity, growing their family, or simply benefiting from a piece of mind. It gives 5 years to avoid going through another cumbersome qualification process if you want to switch lenders in search of better rates.

The 5-year fixed rate is the most popular term as it puts aside the need to negotiate sooner, but if rates don’t rise during your term, then you’re stuck paying more towards interest than what the market expects. Conversely, if rates keep rising and you don’t have any more room in your budget to increase your mortgage after your short-term mortgage ends, you’ll renew once again at a higher rate.  At this time, anyone on a very strict budget who cannot take further increases on their payment is best off locking into a 5-year fixed rate.

In either case, it should be noted that if rates rise higher, breaking your fixed-rate mortgage becomes less costly.  An interest rate differential penalty (IRD) is calculated on how much money your lender hypothetically expects to lose.  If they can turn around and re-lend that money at a higher interest rate, then the calculation on the IRD will be zero, thus leaving you to pay only 3 months’ worth of interest.

Selecting the Right Rate to Save Money on Your Mortgage.

Your mortgage should be selected based on your expectations of the economy at large.  Ask yourself if you expect rates to trend up or down come 6 months prior to the term of your mortgage renewal.  If your expectations are that rates still have a ways to go, then pick a longer term.  If you expect that rates are reaching their limit then you’re better off locking into a shorter term.

Comparing the current 5-year fixed rate you are being offered with the current 2-year or 3-year fixed rates, you should be able to work out if taking the lowest option will keep your interest savings intact.

  • Using the examples from earlier, if your term for the 2-year fixed rate at 5.12% ended and rates hadn’t moved down significantly, then you’d have to replace it with a 3-year fixed rate at 4.73% to get the same savings that you would have gotten by going with the 5-year at 4.89%.
  • Once again, if your term for the 3-year fixed rate at 4.92% ended and rates hadn’t moved substantially, you’d have to replace it with a 2-year fixed rate at 4.85%. 

You can see from these examples that evidently, there is a higher chance that, at the end of your term, you’d be able to renew to get or beat the rate of 4.85% as a 2-year fixed rate – than the likelihood of being able to renew by getting or beating 4.73% over a 3-year fixed rate. Either option is going to cost you more. However, at this time, locking into a 3-year fixed rate will cost you less than the 2-year fixed. Thus providing you with a greater chance of renewing at a lower rate at that time – be it on a 2-year or a 5-year fixed term. Hence, leading back to the decision on your expectations of the Bank of Canada (BoC) to curb inflation and, more importantly, the term that better aligns with your mortgage term’s time horizon.

FAQ

What is the shortest mortgage term in Canada?

The shortest mortgage term offered in Canada is 6 months. Offered as an open mortgage – usually within a collateral charge registration at the Big Banks. Or 6-month closed, which is primarily used as the auto-renewal option on mortgages at the Big Banks. Typically, most lenders will offer a 1-year or 2-year as their shortest term depending on their costs to service such a short loan period.

What are the disadvantages of a fixed-rate mortgage?

The main disadvantages of a fixed-rate mortgage are the interest rate differential penalty (IRD), where the lender calculates the penalty based on the theoretical interest they would have made if you did not payout your mortgage before the end of the term. The other main disadvantage is that if rates should fall over the term of your mortgage, you cannot immediately benefit from the lower rate as both your payment and rate are locked over your term.

Final Thoughts

In the end, if you’re wondering if picking a short-term fixed-rate is the best choice today…The answer is that it’s not for everyone, but it could be the safer option for most. We recommend the 2-year or 3-year fixed rate for those who cannot afford any changes to their payment but still want to save if rates should fall.

For everyone else, we recommend a 5-year variable rate if you can handle a 1% increase in your rate before realizing any interest rate savings should the BoC reverse course in the direction of the overnight rate. The variable rate does come with the most risk today, but also the most upside should inflation fall substantially by the end of 2023.  If both events, inflation coupled with a recession, came to pass, it would lead us to speculate that lower rates would follow.


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