Navigating the labyrinthine of mortgage options can feel painstakingly exhausting for many Canadian homebuyers. Among the myriad of choices, deciding between a 3-year fixed-rate mortgage and a 5-year fixed-rate mortgage often leaves borrowers scratching their heads. 

While both options have benefits and drawbacks, the right choice largely depends on an individual’s financial situation, prospects, risk tolerance and personal economic outlook or opinion. This comprehensive guide will dive into the intricacies of these mortgage terms. How do you decide the path forward? Which one would offer you the biggest savings in the long term? Is there even a wrong choice to make at this moment? We answer all this and more in the article below.

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Key Highlights

• Both 3-year and 5-year fixed-rate mortgages offer unique advantages and challenges.
• Your personal financial goals, market predictions, and risk tolerance should dictate your decision between the two.
• A detailed cost and benefits analysis of various scenarios can clarify the potential outcomes and aid decision-making.

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Choosing Between Fixed and Variable Mortgages

Before we deep-dive into the specifics of 3-year and 5-year mortgage terms, it’s crucial to understand the fundamental distinction between fixed and variable mortgages. 

• In a fixed-rate mortgage, the interest rate and payment remain constant throughout the term, providing borrowers with stability and predictability. 

• On the other hand, in a variable-rate mortgage, the interest rate fluctuates with changes in market interest rates, which can either work in the borrower’s favour or against it. 

You should base your choice on your risk appetite, market predictions and your short- and long-term financial situation expectations.

Why Opt for a 5-Year Fixed Rate Mortgage?

Historically, the 5-year fixed-rate mortgage has been the go-to choice for many Canadians. 

But why is that? 

Lenders advertise and discount their 5-year rates more often than other rates they offer, but this option’s primary allure lies in its stability. With a 5-year term, borrowers can enjoy peace of mind with predictable monthly payments. 

Stability and predictability can be quite a relief in fluctuating market conditions such as the last 18 months and those forecasted recently by the world’s central bankers. However, this security does come at a cost, as 5-year mortgages lock you in for longer than their 3-year counterparts.

Pros of a 5-Year Fixed Rate Mortgage

• Stability: The fixed interest rate for a 5-year term means your mortgage payments remain unchanged for the entire duration. Stability can be especially beneficial for budgeting purposes.
• Security: The longer-term commitment offers a sense of security, shielding you from sudden changes in interest rates.
• Less Frequent Renegotiation: With a 5-year term, you won’t have to renegotiate your mortgage as frequently, saving you time and potentially money.

Cons of a 5-Year Fixed Rate Mortgage

• Limited Flexibility: A 5-year fixed rate doesn’t offer much flexibility, unlike a 5-year variable rate, which allows for early renewal (conversion) into a fixed rate term equal to the remaining term of your variable mortgage without penalty. 
• Risk of Missing Out: If market interest rates fall, you’ll be stuck paying the higher rate until your term ends. 
• Higher Penalties: If you must break your mortgage contract early, prepare for a prepayment penalty. Not all penalties are equal; however, some lenders offer a fair and transparent penalty calculation, but not all. Interest rate differential (IRD) penalties on fixed mortgage rates increase when paying out a mortgage with a currently higher rate in a lower rate environment.

The Appeal of a 3-Year Fixed Rate Mortgage

A 3-year fixed-rate mortgage might not be as popular as its 5-year counterpart, but it has gained traction among Canadian borrowers. 

The shorter term offers flexibility, making it an attractive option for those with uncertain plans or those predicting a drop in interest rates within 3 years.

Pros of a 3-Year Fixed Rate Mortgage

• Competitive Interest Rates: Historically, lenders have offered slightly lower rates on shorter-term mortgages than 5-year mortgages. However, this relationship has inverted as money markets expect inflationary pressures to subside over the longer term. Every lender’s discount is different, so it’s recommended that borrowers shop around when they come up for renewal before accepting their lender’s first offer.
• Flexibility: With a shorter commitment, you can reassess your financial situation and adjust your mortgage terms more frequently.
• Lower Penalties: If you need to break your mortgage early, the penalties associated with a 3-year fixed mortgage term are typically lower than for longer-term mortgages. This lower penalty allows you to take advantage of sudden life changes, other financial opportunities, or changes in your financial situation. 

Cons of a 3-Year Fixed Rate Mortgage

• Less Stability: The shorter term means more frequent exposure to interest rate fluctuations. Many lenders do not offer a discount from their posted rates at renewal time, and this is why you must shop around!
• More Frequent Renegotiations: A 3-year term requires you to renegotiate your mortgage more often, which can be time-consuming and potentially costly.
• Uncertain Future Payments: If market rates rise upon renewal, you could face payment shock with higher mortgage payments.

3-Year vs. 5-Year Mortgages: Which One Is Right for You?

The choice between a 3-year and a 5-year fixed-rate mortgage boils down to your circumstances and financial goals.

• A 5-year fixed-rate mortgage might be your best bet if you desire stability and predictability. 
• Conversely, a 3-year fixed-rate mortgage could be the way to go if you prefer flexibility and the potential to benefit from lower interest rates sooner.

However, mortgage rates can fluctuate rapidly and unpredictably depending on the behaviour of the Canadian and US economies and their respective central banks. 

Therefore, working with a knowledgeable mortgage expert who can help you navigate the market and select the right mortgage product for your unique needs is advisable. Working with a licensed mortgage expert can help you compare rates from different lenders to ensure you get the best deal. 

In the same vein, going to a lender that offers truly lowest rates as advertised on their website, such as nesto, can avoid you having to deal with a middle salesperson who is not selling their proprietary products. Going directly to a lender avoids any origination fees to the broker or bank mortgage specialist while also avoiding a situation where the broker or bank mortgage specialist recommends a specific product or solution based on the commission or bonus they may earn.

Analyzing the Impact: 3-Year vs. 5-Year Mortgages

To further illustrate the potential implications of your decision, let’s look at 4 hypothetical scenarios to complete a cost savings analysis and understand your savings if you had to decide between them. 

These scenarios and calculations are based on an insured 3-year fixed mortgage rate of 5.74% and an insured 5-year fixed mortgage rate of 5.34%, as advertised on nesto’s website on August 31, 2023. In our sample, we’re using a $350,000 original mortgage balance starting at a 25-year amortization.

During the first 3 years of the mortgage payment comparison, on a rate difference of 40bps (1 basis point is equal to 0.01%) between the 2 options, the guaranteed savings over the first 3 years if one chooses the 5-year fixed mortgage will be $3,913. Your savings can be further broken down as $1,351 in the 1st year, $1,304 in the 2nd year and $1,258 in the 3rd year, leaving you with a mortgage balance of $314,521.

Now let’s look at what could happen to your costs-savings in the 4th and 5th for different scenarios.

Scenario 1: Rates Drop by 1% in Year 4

In the first scenario, the market interest rates drop by 1% in the 4th year and remain the same during the 5th year. 

• After 3 years on the 3-year term, you could lock in at a lower rate of 4.74% and save over the 4th and 5th year $3,578 compared to the 5-year rate. 
• The total savings amount to $1,821 in the 4th year and $1,757 in the 5th year, leaving you with a mortgage balance of $292,890 at the end of your 5 years.

Flexibility is the benefit of choosing a shorter term if you expect mortgage rates to drop in 3 years. However, you’d still be left with $334 in guaranteed savings if you choose the 5-year term.

If you had chosen the 3-year term, you would have paid $3,913 more in interest over the first 3 years for the chance to save $3,578 more in years 4 or 5. 

That is a $3,913 risk you are taking to save or potentially pay a truly unknown interest in years 4 and 5.

Scenario 2: Rates Drop by 1.75% in Year 4

In the second scenario, rates dropped by 1.75% in the 4th year and maintained over the 5th year.

•  After the 3 years, you could lock in at a lower rate of 3.99% and potentially save $8,051 in total over the 4th and 5th years over the 5-year rate. 
• The total savings amounts to $4,097 over the 4th year and $3,954 over the 5th year, leaving you with a mortgage balance of $292,890 at the end of your 5 years.

With this scenario, you’d be guaranteed cost savings of $3,913 with the 5-year rate. However, you could expect the flexibility to pay off by locking into a potentially lower rate at the end of your 3rd year, creating a potential cost savings of $4,139 with a higher 3-year rate initially.

If you had chosen the 3-year term, you would have paid $3,913 more in interest over the first 3 years for the chance to save $8,051 more in years 4 or 5. 

That is a $3,913 risk you are taking to save or potentially pay a truly unknown interest in years 4 and 5.

Scenario 3: Rates Remain the Same Through End of Term

In the third scenario, rates stay the same til the end of the 5-year term. 

• After the 3 years, you lock into the same 5.74% rate and produce total savings of $2,386 over the 4th and 5th year on the 5-year rate over the 3-year rate. 
• The total savings amount to $1,214 over the 4th year and $1,172 over the 5th year, leaving you with a mortgage balance of $292,890 at the end of your 5 years.

With this scenario, you would not expect the flexibility to pay off by locking into a similar rate at the end of your 3rd year, creating a guaranteed savings of $6,298 by choosing the 5-year rate.

If you had chosen the 3-year term, you would have paid $3,913 more in interest over the first 3 years for the chance to pay another $2,306 more in years 4 or 5. 

That is a $3,913 risk that you are taking to save or potentially pay a truly unknown interest in years 4 and 5.

Scenario 4: Rates Increase by 1% in Year 4

In our last scenario, rates increased by 1% in the 4th year and maintained over the 5th year. 

• After the 3 years, you would need to lock into a higher rate and produce total savings of $8,349 over the 4th and 5th year on the 5-year rate compared to the 3-year rate. 
• The total savings would amount to $4,249 over the 4th year and $4,100 over the 5th year, leaving you with a mortgage balance of $292,890 at the end of your 5 years.

With this scenario, you expect the stability to pay off by locking into the 5-year rate, creating a guaranteed savings of $12,262 by choosing the 5-year rate.

If you had chosen the 3-year term, you would have paid $3,913 more in interest over the first 3 years for the chance to pay another $8,349 more in years 4 or 5. 

That is a $3,913 risk that you are taking to save or potentially pay a truly unknown interest in years 4 and 5.

We hope these scenarios have illustrated our point that locking into an extended period offers stability and predictability for longer when you expect rates to rise. However, locking into a shorter term provides flexibility and savings if you expect rates to decrease by more than 1% over the term.

FAQs on 3-Year vs. 5-Year Mortgage Savings

Final Thoughts

Choosing between a 3-year and a 5-year fixed-rate mortgage isn’t a one-size-fits-all decision. It depends on various factors, including your financial situation, plans, and risk tolerance. Getting professional and knowledgeable advice from a licensed mortgage expert is recommended. 

Mortgage experts can provide advice tailored to your unique circumstances and help you navigate the complex world of mortgages. Remember, informed decisions make for better long-term financial health.

If you’re renewing your mortgage or buying your first home, contact nesto’s mortgage experts to find the most suitable mortgage and rate for your situation. Reach out today, and we’ll connect you with one of our mortgage experts to answer all your questions.

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