By Mark Kerzner, President, TMG The Mortgage Group Canada Inc.
When I worked as a lender we saw a lot of Adjustable Rate Mortgages (ARMs) - variable rate transactions. From the early-to-mid-2000s that product seemed to be the mortgage product of choice by the brokers we worked with.
Many brokers devised strategies to demonstrate how the ARM was more advantageous to the homeowner than a standard fixed rate mortgage. The "pitch" ranged from paying less interest, to having lower payments, to aggressive principal reduction, and so on. With the benefit of hindsight, for those consumers who chose variable rate products throughout the last decade, they have, for the most part, come out well ahead.
With fixed interest rates continuing to hover at historical lows (5-year fixed rates are approximately 3.09% to 3.29% at the time of this writing) and the small spread between discounted ARMs and fixed rates right now, consumers are choosing fixed rate mortgages. The main advantage for choosing a fixed rate is that payments and rates do not change over the term of the mortgage. The most popular term is the 5-year fixed, although the 10-year fixed rate is starting to take on some momentum of its own.
A couple of years ago the Government of Canada began changing mortgage qualification criteria. One change was to use a benchmark interest rate to qualify buyers for ARMs and for fixed terms less than five years. The benchmark rate is tied closely to the bank’s posted 5-year rate, which is currently 5.24%.
The reason for this change is that ARMs and shorter term mortgages are vulnerable to higher interest rates when the mortgage renews. By building in a buffer, in this case making sure clients qualify at the higher benchmark, then at renewal, if the interest rates have increased, there is less payment shock. It also ensures that mortgage holders would be able to afford higher payments. That interest rate buffer now sits at more than 2% for clients taking out ARMS for terms less than 5 years. That means if you choose to take one of those products you have to be able to make payments on them if rates were to rise by 2%.
Once a client has decided to take a fixed term mortgage as opposed to an ARM then the next question is what term to take. Generally speaking, the longer the term you choose, the higher the interest rate. The rate for a longer fixed term may be higher but it also offers greater security against a future rise in interest rates. My advice to all mortgage consumers today would be to set your payments as if you took the 10- year term whether or not you select that product.
If selecting a fixed rate product is similar to purchasing interest rate insurance, then purchase the insurance that is likely to pay you back in the end. If the amount of “insurance” you pay during a term results in a lower principal balance at the end of the term than that is like being paid back at the expiry of your mortgage term.
Here is an example:
Let’s take a conventional 5-year mortgage, which is under 80% loan-to-value, which also means there are no additional mortgage insurance premiums. Let’s assume a mortgage amount of $250,000 amortized over 25 years. Payments are monthly, compounded semi-annually. The seven and 10-year terms illustrated below are examples if you were to set your payments on your 5 year fixed term at the corresponding rates of each of the 7 and 10 year terms. The Total Payments and Balances at Maturity are the amounts at the end of five years.
Term Rate Monthly P&I Total Payments Balance at Maturity
5-year 3.29 $1,220.63 $73,237.80 $214,863.60
7-year 3.69 $1,273.38 $76,402.80 $211,430.47
10-year 3.89 $1,300.19 $78,011.40 $209,685.57
As illustrated above you are paying more over the life of the term but you are also accelerating the principal repayment by an even greater amount. More aggressive strategies would have you setting your payments at the benchmark rate, which is the rate that the government is suggesting all consumers should be qualified at. If you choose, and can afford this option, you will benefit by aggressively paying down your principal during the current term. That will create numerous options for you down the road including;
1. Greatly reducing the amount of interest you pay over the life of your loan.
2. Significantly reducing the number of years it will take to repay your mortgage in full.
3. Providing you with options at (term) maturity. For example, you may decide to change the amortization to free up cash flow.
There is also another way to get the benefits without burdening your cash flow-- simply choose the accelerated bi-weekly payment options. This means you are making set payments every two weeks, which comes out to 26 payments a year.
If cash flow permits, consider combining the 10-year payment option with accelerated bi-weekly payments for added savings and balance reduction.
These options do require necessary cash flow and in many cases money may be tight right now. The beauty of a fixed rate mortgage option is that you can start this strategy at any point. If times are tight right now you can start in a year or two.
There are so many options to consider when dealing with mortgage products and there is an option that fits your individual need and situation. Talk it over with your mortgage broker.
When I worked as a lender we saw a lot of Adjustable Rate Mortgages (ARMs) - variable rate transactions. From the early-to-mid-2000s that product seemed to be the mortgage product of choice by the brokers we worked with.
Many brokers devised strategies to demonstrate how the ARM was more advantageous to the homeowner than a standard fixed rate mortgage. The "pitch" ranged from paying less interest, to having lower payments, to aggressive principal reduction, and so on. With the benefit of hindsight, for those consumers who chose variable rate products throughout the last decade, they have, for the most part, come out well ahead.
With fixed interest rates continuing to hover at historical lows (5-year fixed rates are approximately 3.09% to 3.29% at the time of this writing) and the small spread between discounted ARMs and fixed rates right now, consumers are choosing fixed rate mortgages. The main advantage for choosing a fixed rate is that payments and rates do not change over the term of the mortgage. The most popular term is the 5-year fixed, although the 10-year fixed rate is starting to take on some momentum of its own.
A couple of years ago the Government of Canada began changing mortgage qualification criteria. One change was to use a benchmark interest rate to qualify buyers for ARMs and for fixed terms less than five years. The benchmark rate is tied closely to the bank’s posted 5-year rate, which is currently 5.24%.
The reason for this change is that ARMs and shorter term mortgages are vulnerable to higher interest rates when the mortgage renews. By building in a buffer, in this case making sure clients qualify at the higher benchmark, then at renewal, if the interest rates have increased, there is less payment shock. It also ensures that mortgage holders would be able to afford higher payments. That interest rate buffer now sits at more than 2% for clients taking out ARMS for terms less than 5 years. That means if you choose to take one of those products you have to be able to make payments on them if rates were to rise by 2%.
Once a client has decided to take a fixed term mortgage as opposed to an ARM then the next question is what term to take. Generally speaking, the longer the term you choose, the higher the interest rate. The rate for a longer fixed term may be higher but it also offers greater security against a future rise in interest rates. My advice to all mortgage consumers today would be to set your payments as if you took the 10- year term whether or not you select that product.
If selecting a fixed rate product is similar to purchasing interest rate insurance, then purchase the insurance that is likely to pay you back in the end. If the amount of “insurance” you pay during a term results in a lower principal balance at the end of the term than that is like being paid back at the expiry of your mortgage term.
Here is an example:
Let’s take a conventional 5-year mortgage, which is under 80% loan-to-value, which also means there are no additional mortgage insurance premiums. Let’s assume a mortgage amount of $250,000 amortized over 25 years. Payments are monthly, compounded semi-annually. The seven and 10-year terms illustrated below are examples if you were to set your payments on your 5 year fixed term at the corresponding rates of each of the 7 and 10 year terms. The Total Payments and Balances at Maturity are the amounts at the end of five years.
Term Rate Monthly P&I Total Payments Balance at Maturity
5-year 3.29 $1,220.63 $73,237.80 $214,863.60
7-year 3.69 $1,273.38 $76,402.80 $211,430.47
10-year 3.89 $1,300.19 $78,011.40 $209,685.57
As illustrated above you are paying more over the life of the term but you are also accelerating the principal repayment by an even greater amount. More aggressive strategies would have you setting your payments at the benchmark rate, which is the rate that the government is suggesting all consumers should be qualified at. If you choose, and can afford this option, you will benefit by aggressively paying down your principal during the current term. That will create numerous options for you down the road including;
1. Greatly reducing the amount of interest you pay over the life of your loan.
2. Significantly reducing the number of years it will take to repay your mortgage in full.
3. Providing you with options at (term) maturity. For example, you may decide to change the amortization to free up cash flow.
There is also another way to get the benefits without burdening your cash flow-- simply choose the accelerated bi-weekly payment options. This means you are making set payments every two weeks, which comes out to 26 payments a year.
If cash flow permits, consider combining the 10-year payment option with accelerated bi-weekly payments for added savings and balance reduction.
These options do require necessary cash flow and in many cases money may be tight right now. The beauty of a fixed rate mortgage option is that you can start this strategy at any point. If times are tight right now you can start in a year or two.
There are so many options to consider when dealing with mortgage products and there is an option that fits your individual need and situation. Talk it over with your mortgage broker.
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