Our slightly late instalment for this evening comes as a response to the unexpected drop in Bank of Canada's key lending rate this past week. Another of the many questions we're frequently answering for our clients involve changes in lending rates, and what it means for their lives, going forward.
In the past eight months, there has been a sharp increase in mortgage refinances and early renewals. Why? Canadians are visiting their branches (and other banks), looking for a new lower-cost alternative for their home financing.
Have you reviewed your mortgage? Have you visited your branch to see what they're willing to do to save you money? To keep your business? What we're going to cover today are the basics of lending rates, and what they mean for you and your existing mortgage. In our three-part report on mortgages, we're going to explore Real Estate Lending and how to save you money.
Tonight, we're going to explore the basics: Mortgage Rates, and types of Residential Mortgages.
Rates and Terms
First, mortgage rates and mortgage terms. It's worth exploring what kind of rates are generally available on different kinds of financing options, as well as what influences changes in those rates, and what you can do to take advantage of those changes to your benefit. It's also worth looking at the role that your mortgage term can play in your financial planning, and how you can decide which is best for you.
The rates that are available at any bank depend on the kind of mortgage. That's right, there are different kinds. Fixed, Variable, Open, Closed, Convertible. It's sometimes difficult to keep them straight! So let's make our first step to explore what all of these mortgages are.
The "term" is the period of time for which that rate is guaranteed. For example, a 5 Year Fixed Rate mortgage is one where the rate is set and guaranteed ("fixed") for a period of five calendar years. It won't change, even if the rates available for fixed rate mortgages change during that time. You have a choice in your term. Major Financial Institutions will typically offer terms between 6 Months and 10 Years. (Usually 6 Months, 1, 2, 3, 4, 5, 7, 10 Years).
"Which term should I choose?"
The term that's the most beneficial for you depends on your personal situation, your willingness to risk your rate, as well as how long you plan to stay in the property. There's something else to keep in mind aside from these considerations: sometimes it's worth arbitrarily taking a common rate, like 4 or 5 Years, in order to obtain a low rate. Or, take a shorter term to try and take advantage of rate changes. Or again, take a longer term to try and hold onto a rate guarantee for as long as possible. There are many other factors that go into whether a particular term works better for you, so let's explore them:
- Short-Term Mortgages (6 Month, 1-3 Years)
Do you plan on selling the house in only a few years? These are perfect for those of you who definitely plan on staying in your property for a short period of time. Why? It means that if you want to pay out the mortgage (and in doing so, break the term early), your PrePayment Charge will be lower. (we'll explore this in detail later)
Are you open to the possibility (and pitfalls) of market volatility? Having a short-term mortgage does also mean that if there are rapid changes in the market and economy over a short amount of time, mortgage rates may fluctuate rapidly during that short period, meaning you may be able to save more money by essentially "holding out" for rates to go lower during a short amount of time. However, you may end up having a higher rate than you did originally as well.
- Common Mortgages (4 and 5-Years)
You have rate security for a moderate amount of time, without being locked in for a long term such as 7 or 10 years. Having a long term mortgage means that you're committing yourself to a rate over a lengthy amount of time, during which you could see rate changes that you otherwise would have been able to take advantage of.
As mentioned already, since these terms are the most common, the best rates are usually available on 4 and 5 Year Mortgages. If you give even a casual glance at mortgage rates offered by financial institutions and other mortgage lenders, you will notice that they will primarily compete on their 4 and 5-Year Mortgages.
If your primary concerns are cost savings, consider taking a term that comes with a low rate.
- Long-Term Mortgage (7-10 Years)
However, these mortgage terms are comparatively rare to shorter terms. While you have considerable rate security, there are a few downsides as well. Primarily, financial institutions will not compete on these rates to a great degree simply because they aren't in high demand. Also, the rates are usually much higher than the shorter term and common mortgages.
Even in volatile times such as the present, when rates are changing often and projections put rates on an increase with expected inflation over the next 2 to 5 years, thus far in our experiences there has not been a trend away from the common mortgage terms, when many consumers are looking for more rate security than in the past.
If you're looking for long-term security, and plan on being in the property for a long time, this can be beneficial for you, but the rate security may be a trade-off against having the flexibility to take advantage of lower rates sooner.
These are the kinds of terms that are available. From short to long term, there are various advantages (and disadvantages) to each. The one that's best for you is the one that fits with your personal willingness for rate risk, as well as how long you plan on staying in the house.
"What rate is best for me?"
Next, we will explore what kinds of rates you can get over those terms. Mortgage "types" are categorized into the type of rate that you have- either fixed or variable. A fixed-rate mortgage gives you the rate security the we talked about above with regards to terms. A variable-rate mortgage fluctuates with your bank's Prime Rate, and while it offers no such security, the rate is often lower than a fixed rate.
- Fixed-Rate Mortgage
What's in it for you? A Fixed Rate Mortgage is ideal for those of us who prefer not to be open to market volatility. The fixed rates that are available are, in one way or another, influenced by changes in the market, and will change multiple times throughout the year. If you can imagine it, over five years, mortgage rates make change several dozen times.
A fixed rate mortgage is beneficial for someone who wants rate security and predictable payments. If your rate doesn't change, it means that the amount of interest you pay doesn't change, which means that your averaged monthly payments will be the same.
- Variable Rate Mortgages
With Prime Rates being the lowest in ten years, financial institutions are largely not giving discounts on these mortgages, whereas in the past discounts were available with negotiation. Variable Rate mortgages are generally working on "Prime Plus", meaning the interest rate is an institution's Prime plus a small fixed rate.
- For example, a Five Year Closed Variable Rate Mortgage may be at "Prime + 0.80%", meaning that it will always be 0.80% over whatever that institution's Prime Rate is.
This last possibility is the largest disadvantage to Variable Rate mortgages. However, depending on whether you have an Open or Closed mortgage, you may have the opportunity to lock in your rate based on what Fixed mortgage rates are available.
Pre-Payment Policies
To continue on that thread, next we'll explore Closed and Open mortgages. This refers to the Pre-Payment Policy that's attached to your mortgage. What's a Pre-Payment Policy? It's exactly as it reads. It's the policy as written by your bank that controls how much you can put against your mortgage in lump sum payments (or pre-payments) per calendar year.
- Closed Mortgage
Let's say you opened a closed mortgage in the amount of $300,000.00, and your pre-payment policy allows for 15% down payments. This means you can put up to $45,000.00 per calendar year against the principal amount of the mortgage, which is the amount that you owe.
There's a definite advantage to being able to make lump sum payments against your mortgage. It lowers the amount you owe immediately, as lump sum payments go directly against the principal, which is the amount you actually owe.
Doing such a payment doesn't pay your interest down for you, but because of the lump sum payment, your interest cost becomes lower. Why? You're paying off a smaller mortgage!
However, there is another side to a Closed Pre-Payment Policy. If you re-finance a Closed Mortgage, you're essentially paying the entire mortgage out in full so that it can be replaced by another one. Paying out a mortgage in full is obviously more than 15% or 20%! This is usually referred to as "breaking" your mortgage.
If you break this mortgage early, either by re-financing or paying it out, you incur a Pre-Payment Penalty. This is very important to research and keep in mind when deciding whether or not to refinance or to pay out your mortgage early (aside, of course, from selling the property).
"Is this right for me?"
The majority of Canadian mortgagors have Closed mortgages, and they are exceedingly common versus an Open mortgage. The primary reason for this is that Open mortgages, which we will explore next, do not have a lot of diverse rates available.
If your primary concern is to have a lower rate for a period of time, and you're not really planning on leaving the property, take a Closed Mortgage, since the rates are generally always better.
- Open Mortgage
Open Mortgages are best suited when you plan on keeping the property for a very short amount of time, or if you want to have constant flexibility to refinance. Having the flexibility to pay off your mortgage early via an Open Mortgage generally reflects a short-term need, rather than a long-term need for financing by consumers. As such, low rate security is usually not a primary concern. This is a very flexible option, however, the rates are almost always going to be higher, and you won't have as many terms available to you.
Let's be objective. Since these mortgages offer no guarantee to the bank that they will have sustained revenue for a fixed period of time, the available rates will be much higher than they would be for Closed Mortgages.
Always consult a mortgage specialist if you're concerned about whether an Open Mortgage would be right for you. As we've just explored, they are very different from other mortgages, and should only be used as a financing option when it will actually benefit you for a short amount of time.
That's all we have for our first instalment on Mortgages. Tonight we explored the differences and benefits between short and long terms, fixed and variable rates, as well as pre-payment policies. As always, we encourage responses, questions, concerns, and constructive opinions on our content.
In our next instalment, we'll be looking at Re-Financing. Watch for it!
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