Why new homeowners should go long

It was a cold March day in 1990. My buddy Kevin and I were on a lunch break with the engine idling in a McDonald’s parking lot. He was torn over whether he should lock into a five-year mortgage at 12 percent. I told him he was crazy not to.

Now, before you consider me a bad friend, let’s put that advice in context. Eight years earlier five-year mortgages came within a hair of twenty percent.

Bank of Canada records show the average five-year mortgage rate in 1990 went from 12 percent in January to 14.2 percent in May, and there was no way of knowing whether those dark days of twenty percent mortgages were returning.

Fast-forward to the present

Central banks around the world (including Canada) continue to lower their expectations for economic growth in the wake of the biggest global economic meltdown since the Second World War. To avoid a spending freeze they are trying to heat up the flow of money by maintaining their trend-setting interest rates as close to zero as they have ever been. The next step is to pay people to borrow, and that’s how crazy things have gotten.

The lingering uncertainty appears to have sparked yet another mortgage war in Canada after BMO lowered its five-year fixed rate to 2.99 percent this week – but this mortgage war is different. With the outlook beyond five years so murky, longer term rates have been coming down faster than short term rates, making the difference between short and long-term rates slim.

According to RateSupermarket.ca, rates on a ten-year mortgage right now are as low as 3.6 percent compared with the lowest one-year mortgage of 2.3 percent. Compare that to the average ten-year mortgage rate of 6.4 percent in 2009, and it’s not hard to see the appeal of locking in at ten years.

Fast-forward to the future

The year is 2023. Much of the slack from the great meltdown of 2008 has been removed from the economy and mortgage rates are back in line with historic averages.

A homeowner who locked into a ten-year fixed rate mortgage at 3.6 percent back in 2013, with a $250,000 mortgage amortized over twenty years and biweekly payments of $671, now owes $147,000. Total interest on the loan would be $72,000.

In comparison, homeowners who took variable or shorter fixed-terms had to renew at higher rates and will have paid much more.

Let’s assume the average rate over that ten year period was six percent. Under the same circumstances the homeowner would have had to make biweekly payments of $820 just to get that $250,000 mortgage to $161,000. Total interest on the loan would be $124,000.

Over course of that decade homeowners who went short paid $149 more every second week to service the mortgage, $52,000 more in interest to the bank and accumulated $14,000 less equity in their homes.

Some Things Never Change

A new survey conducted by Harris/Decima research for CIBC shows over half of homeowners aged 25 to 34 say they would choose a fixed over variable rate mortgage if they had to decide today.

That’s a smart choice for the times but no matter what happens in the broader economy, it’s always important to ensure more of your dollars go toward equity on your home and not interest for the bank. You do that by choosing the lowest rates over the long term.

And there’s a less tangible, timeless benefit to locking in long. It can provide security and stability for young homeowners like Kevin who normally have big mortgages, small paycheques and plenty of expenses to start their lives. A sudden change in rates can be a big shock that is difficult to absorb.