Can you explain the advantage of a 10-year mortgage (Canada)?
February 5, 2015 7:02 PM   Subscribe

Buying a house here in Canada, and my mortgage broker has mentioned that we're in an unprecedented mortgage rate slump, with five-year fixed at about 2.7% and now 10-years at around 3.8%. I can sort of figure out some math here, but I'm not sure I grasp the full nuances of this decision with compound interest, etc.

As I figure it, taking a 10-year mortgage at 3.8% vs. a five-year at 2.7% is essentially a bet that mortgage rates will be higher than 4.9% for the second five-year term (with the 10-year rate as the median, the second five-year rate would have to exceed the initial difference, in the wrong direction, for this to be worthwhile.

Historically speaking, I definitely feel that interest rates over 5% are more the norm than the exception in Canada, and that locking in this longer, lower rate may be prudent.

But I don't really get compound interest, and I wonder if the math really is that simple. The monthly payment difference between the five- and ten-year rates, with the size of the mortgage we'll have, is not a huge factor (we're buying within our means, with a substantial down payment), and the peace of mind of locking and forgetting sounds kind of nice.

But am I missing something that makes a 10-year mortgage at historically pretty low rates a bad idea?

I'm in Canada, if that makes a difference, and in a city that isn't a hot market, where housing prices stay pretty stable and there isn't any Toronto-style speculation or expectation of either massive rises in value or fears of bubbles bursting.
posted by Shepherd to Work & Money (9 answers total) 4 users marked this as a favorite
To figure out the interest rate for the month, use =(1+E2/2)^(1/6)-1, where cell E2 contains the posted rate. To figure out the mortgage balance after one month, use this rate to calculate the interest charged, add that to the principal and subtract your monthly payment. In a spreadsheet it is possible to figure out the rate for years six to ten that will give you the same balance after ten years, assuming you are making the same monthly payment. When I did this, I got a rate just under 5.4% but I picked a mortgage payment mostly at random.

You can take the lower rate mortgage and make monthly payments based on the higher rate. The higher you make your monthly payment now, the higher the interest rate for the second five years would need to be to end up with the same balance at the end of ten years as the fixed ten year rate scenario. I just increased the monthly payment by 10% and the rate for years six to ten could now be just under 5.5%. Are you planning on making extra payments?

*Canadian fixed mortgage rates are stated as a bond style rate, variable rates are stated as an annual rate with monthly compounding
posted by TORunner at 7:38 PM on February 5, 2015 [3 favorites]

I second TORunner's calculation.

One thing I would worry about is the penalty for breaking the mortgage. On a fixed rate mortgage you're generally going to be charged the higher of 3 months interest or the interest rate differential (IRD). If you have a 10 year mortgage that could make for an extremely high IRD if you end up selling the house after a few years. Even if you aren't planning on moving, a lot can change over 10 years so that flexibility is worth something.
posted by any portmanteau in a storm at 7:43 PM on February 5, 2015 [1 favorite]

You are buying peace of mind. Variable rates have been a better move over the last 10 years. But with rates so low and for long term planning you may prefer to lock things in. You can plug the numbers into a mortgage calculator to figure out how much interest you'll repay under the various scenarios. The most popular mortgage in Canada is 5 year fixed. In the end it comes down to how comfortable you are dealing with risk.
posted by Cuke at 7:45 PM on February 5, 2015 [2 favorites]

People with variable mortgages can get some very unpleasant surprises. For example, in Poland last year, rates doubled. That's less likely to happen in a country with extremely stable banking like Canada. But it can happen.

My personal feeling is that having a mortgage rate go down is a nice Christmas present, but having it go up can result in having to leave my home, so I'd rather lock in the rate.
posted by musofire at 8:04 PM on February 5, 2015

I locked in once, a long time ago, because of the 'I can't afford an interest rate increase' factor, it cost me but the peace of mind was worth it.

You are betting against the banks if you think it will work out cheaper - you think you are smarter? I don't think I am, and would only do it again if the certainty factor was the determinant.

You can always split your loan, so you risk less and stand to gain less too. The break cost is a real risk, and the longer the period, the higher the risk.
posted by GeeEmm at 2:49 AM on February 6, 2015

As Cuke says, you're betting for a (substantial) prime rate rise in ten years with the 10-year option.

That said, 3.8 is not more (and even sometimes less than) the rate we've been getting historically for 1 or 2 year fixed terms for the past decade.

On the other hand, I don't see huge pressure upwards for the next few years either. The BoC is widely assumed to be contemplating a further rate cut right now. The major lenders are currently offering significantly higher rates than prime , which is also unusual.

We're in an odd situation right now. The central bank is trying to soft-land the bubble markets in the major cities by easing lending rates, which are essentially 0 already. The major banks are on the edge of their own profitability with retail mortgages and don't want to go much further down. Oil prices are depressing demand in some of the previously hottest markets, reducing demand for mortgages.

Looking for longer-term certainty may not be the worst strategy. Rates are very low right now. I've personally had great success going with 1 year fixed terms on our mortgage(s), resigning annually, but that rate is tempting.
posted by bonehead at 6:40 AM on February 6, 2015

Am I missing something about how Canada does it? I thought that fixed rate mortgages calculated payments so you paid that interest and all of the principle in that term. So after five years of a five year mortgage, you'd be done paying. With a ten year, in exchange for a slightly higher interest rate, you get to spread those payments out to ten years.
posted by advicepig at 7:38 AM on February 6, 2015

No, that's not generally how Canadian mortgages are negotiated. We typically are offered a contract (a term) for a fixed (or sometimes variable) rate of interest for 6 months to 5 years. At the end of the contract, a new one is negotiated and a new rate for the next period is agreed to. There are provisions for what happens if you don't re-sign, of course, your debt doesn't suddenly come due or anything.

Normal payout periods ("amortizations") are 20 to 25 (max) years. The government used to allow longer ones, but cracked down on that a few years ago.

You can read about how it works here.
posted by bonehead at 7:55 AM on February 6, 2015 [2 favorites]

Whichever term you go for, up the frequency to as high as possible. You'll save a bucketload of cash by making weekly payments vs. monthly, even if your weekly payments are a quarter of the monthly amount. You can make compounding work for you instead of against.
posted by kate4914 at 8:50 AM on February 6, 2015 [1 favorite]

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