When Ashley Sparkman and her husband Dave were buying their first house in Welland, Ontario, they didn't think they'd be moving just a few years later — but plans quickly changed.
Had the young couple thought ahead — the job prospects in the area were slim, especially for Dave, a recent teacher's college grad — they might have opted for a different mortgage term than the 5-year fixed rate they locked in at in December 2010. They've since moved to Kingston and listed their home for sale, but are facing a hefty penalty for breaking their mortgage before the original term was up.
According to Vancouver-based mortgage broker Dara Fahy, selecting the wrong mortgage term is one of the most common mistakes first-time homebuyers like Ashley and Dave make.
Selecting the wrong term
In the Sparkman's case, a 5-year fixed mortgage term was an attractive option at the time. They liked the stability of always knowing what their monthly mortgage payment would be and the rate they were offered was low.
"It wasn't worth the financial gamble for us at the time," said Ashley, "and we knew we'd have to pay a penalty to get out [of our mortgage], but we didn't put much thought into it or think it was a big deal."
As it turned out, it was a bigger deal than they initially thought. In order to break a fixed rate mortgage early, homeowners are charged either three months' interest or the Interest Rate Differential (IRD), whatever is greater. Ashley and Dave's home is currently listed for sale and, with approximately $100,000 left on their mortgage, if they sold today they'd be paying an IRD penalty of over $2,500.
Comparatively speaking, the penalty the Sparkman's are facing is actually fairly low. If they still owed $300,000, their IRD penalty would be closer to $7,500.
"Really the only way to protect yourself from a large penalty is to assess the market," explains Toronto mortgage broker Christopher Molder. "With a variable rate, the penalty is always three months' interest. Given the options at the time, if they knew there was a chance they would sell within two-to-three years, a variable rate could have saved them money since interest rates have dropped."
In Ashley and Dave's case, if they had selected a 5-year variable rate, their penalty would ring in at just $950. Their other option - had they known they might sell early - would have been to select a shorter term, such as a 3-year fixed rate.
"Next time around, we will probably take our time shopping around for rates, terms and such, rather than just going into the bank we're with because it was easy," she said.
Focusing too much on interest rates
With the low mortgage rates currently available in Canada, it's hard not to want to get the best one. Many times, a lender will offer clients a lower rate for a mortgage that has little-to-no flexibility. This means while the client might be getting a low rate, they won't be getting many other popular features like prepayment options or rate holds. A rate hold allows the homeowner to lock into the current mortgage rate between 30-120 days before their renewal date, which can be particularly helpful if rates are likely to increase. This lack of flexibility can end up costing more money in the long run.
If a deal sounds too good to be true then it probably is," said Molder. "In a market where most borrowers are fixated on rate, it is easy for lenders to structure mortgages in such a way that the rate looks good but they eliminate all other privileges."
While the terms and conditions that come with a mortgage might not seem important when you're signing the paperwork, the effect they can have a few years down the line is paramount. For instance, low rates might come with stipulations regarding prepayment options, or owners might not be able to break their mortgage without paying the entire term's interest.
While it can be tempting to lock into the lowest rate available, it's important to consider the entire mortgage package and any restrictions, before signing.