Mortgages: To lock-in or not?

With all the hype around mortgage rates increasing, as opposed to writing directly about this I found a great piece from Ed Rempel. He really covers the “to lock-in or not” debate very well.

Avoid the 5-Year Fixed Mortgage Trap

Should I go short or long; fixed or variable with my mortgage?
“I wish I had an answer to that, because I’m tired of answering that question.” – Yogi Berra

Number 3 on our list of things on which Canadians waste the most money is 5-year fixed mortgages.
They are marketed as being safe and a good protection against a sharp rise in interest rates. The reality, though, is that they are nearly always a huge waste money, they limit your flexibility and result in losing your negotiating power for 5 long years.
That is why we call it the “5-Year Fixed Mortgage Trap”.

I am not a mortgage broker, but have researched mortgages and always have strong opinions. The most common questions about mortgages are “short vs. long” and “variable vs. fixed”. Which is better? Canadians often debate this, but studies consistently show that short beats long and variable beats long term fixed.
If it is so obvious, then why doesn’t everyone see it? Longer term mortgages are marketed heavily by banks and mortgage brokers that make far more money on them then short term mortgages. Also, most people are bad at math and may get a general feeling of security from a fixed rate, but they do not do the math on how much this protection costs or the odds that they will lose money.

“Unfortunately, most of the existing folklore and advice is rarely subjected to formal statistical analysis and does not address the probability that a given strategy will be successful.” (Moshe Milevsky) The main reasons commonly used for taking 5-year fixed mortgages turn out to essentially be myths:

3 Mortgage myths about 5-year fixed mortgages:

1. They are safer
A study by Moshe Milevsky, finance professor at York University, from 1950-2000 showed that the average Canadian wastes $22,000 after tax (based on a $100,000 mortgage for 15 years) in their life because they got sucked into 5-year fixed mortgages rather than variable.

If your mortgage started at $300,000, then you can expect to waste $66,000. They also took on average 38 months longer to pay off their mortgage. The chance of losing money over 5 years was 89%. A study by Peter Draper (mortgage broker) comparing 5-year vs. 1-year mortgages from 1975-2005 showed that the 1-year mortgage saved money 100% of the time! How can an 89-100% chance of losing thousands of dollars be safer?

2. Rates may go very high like in the 1980s
I was an accountant for a mortgage company in 1982 when mortgage rates peaked at 22.75%. My first mortgage was a 5-year fixed in 1980 at 13.75%. I thought that I had lucked out, since rates jumped to 22.75% and were back to 13.75% by 1985 when it came due. What I didn’t realize was that, even then, I would have saved money by going variable! Based on Peter Draper’s study, I would have lost money for 2 years and saved money for 3 years. So, even with a huge leap of 9% in mortgage rates in the first 2 years of my mortgage, I still lost money with a 5-year fixed rate!

Also, the odds of a huge rate rise are extremely low. We can’t calculate them, since it has only ever happened in the early 1980s, but the odds must be extremely low. Demographers, like Harry Dent, claim it related to Baby Boomers entering the housing market for the first time, which is a phenomenon we don’t expect to be repeated in the next few decades.

3. Your mortgage payments will stay the same
Most variable mortgages also keep your mortgage payment the same during the term. Many people believe that their mortgage payment will fluctuate with a variable mortgage, but this is also a myth.

Top 4 reasons to stick to short or variable mortgages:

1. Save thousands
On average, you should save 22% of the starting amount of your mortgage and pay it off 38 months earlier. (Moshe Milevsky) In the Toronto area, an average mortgage is $2-300,000, which would be savings of $44-66,000 after tax. That is essentially one full year’s earnings, so the average person works one extra full year just to pay the money wasted by taking 5-year fixed mortgages!

2. Low risk
With variable mortgages, the chance of saving money is 89-100%. Yes, the variable is the low risk!

3. Flexibility
Many things can happen in your life in 5 years that may make it advantageous to refinance. You may want to move, roll in other debt to get the lower rate, make extra payments with no limit or change some terms. Our experience with our clients is that most do some sort of refinancing every couple of years, so being locked in for 5 years is a long time.

4. Negotiating power
The mortgage market is very competitive, so every time your mortgage comes due, you have lots of negotiating power. You can change any term you want, get a free appraisal, negotiate a lower rate, or get an unsecured credit line or other banking service. During the term, you have hardly any power. Remember that when you sign a 5-year mortgage, you sign away your negotiating power for 5 years!
The main reason that 5-year fixed mortgages lose money vs. 1-year is that, in a normal market, they start about 2.5% higher. If you pay 2.5% more in year 1, you need the average for years 2-5 to be more than 3% higher than today’s rate. To be ahead, rates would have to jump by more than 3% and stay there for the next 4 years – a very unlikely scenario.

Conclusions:

1. Stick to 1-year fixed or variable mortgages. Usually, you should take whichever is lower, but only take variable at a good discount, such as prime -.8-.9%.

2. Avoid 5-year fixed. Sometimes, they are tempting, but always assume they will end up costing much more, plus you will have lost your flexibility and negotiating power for 5 years. Remember that even when rates leaped 9% in 2 years from 1980-82, short term rates still saved money.

3. Never take a mortgage term longer than you expect to stay in your current home.

We have been referring people to mortgage providers since the mid-90s and most today have rates below 2%. Most of our clients still have the prime -.85% rate that we had for years before this recent crisis or have our recent 1-year rate of 1.99%.
Today, we are recommending 1-year fixed, not variable. The best variable rates are prime -.4-.6%, but rates are normalizing quickly. We expect that the prime -.85% (or lower) rates will be back soon. We expect that anyone taking a variable today will regret having locked in before the larger discount is available.

Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Saverio Manzo
www.saveriomanzo.com