The average length of a mortgage in Canada is between 25 and 30 years (longer amortizations are usually better). But when you get a mortgage, you’ll only be getting a term for much less time (usually 5 years or less). What gives?
The length of your whole mortgage is not the same as the length of your mortgage term. So what is a mortgage term?
A mortgage term is an agreement between you and your lender that defines how long a certain interest rate will be in effect. Aside from the interest rate, it will also dictate the type of rate (fixed or variable) and any pre-payment penalties or privileges. Once your term ends, you’ll either have to renew your mortgage, refinance it, or pay it in full.
The longest mortgage term in Canada is 10 years, but those are rare. The majority of mortgage terms last for 5 years, which is the length of time the Bank of Canada uses to determine its qualifying benchmark rate. The benchmark rate is the minimum rate you have to qualify at when applying for your mortgage – even if your actual rate is much lower. You have to use the benchmark rate when stress testing your mortgage.
Unless you have an open mortgage, you’ll have to pay the lender a penalty when you break a mortgage in the middle of your term, such as when you move. There are two ways of calculating the penalty, either 3 months’ interest or using a formula called the interest rate differential (IRD).
Depending on how your lender calculates your penalty, you can end up paying thousands of dollars in penalties when you break your mortgage. You should always carefully review your mortgage commitment and make note of the penalty. Sometimes saving money on the interest rate isn’t worth it if you have to break your mortgage.
Fixed rates have higher penalties than variable rates, so keep that in mind when deciding on your rate.
An open mortgage can be paid off in full at any time with no mortgage pre-payment penalty. Closed mortgages have set pre-payment privilege rules and penalties for breaking those rules. So why would anyone ever choose a closed mortgage? Open mortgages have markedly higher interest rates, that’s why.
For example, on RateShop.ca right now (September 7, 2018) the best 5-year variable mortgage rate is 2.65%. The cheapest open variable mortgage is 4.20%. So you’d save money on penalties if you paid it off early, but in the meantime you’d be paying $227 more a month (on a $300,000 home with 10% down). By contrast, the prepayment penalty for that mortgage could be as low as $2,200 – equal to just 10 months of payments! Unless you sold your house within 10 months of buying it, it wouldn’t be worth it to pick an open mortgage.
Open mortgages are best for short-term financing when you know you’ll pay off the full balance in a short amount of time. Closed mortgages are best for the average mortgage borrower.
A fixed mortgage rate stays the same for the entire term of the mortgage. The best 5-year mortgage rate right now is 3.34%, so your rate would stay at 3.34% for 5 years. This can be tempting when rates are rising like they are now. Rates didn’t increase on Wednesday, September 6, 2018, but they probably will on October 24.
A variable mortgage rate goes up and down with prime rate – the rate that banks base their lending rates on. Prime rate is increased or decreased whenever the Bank of Canada decides to change their policy rate, and they make 8 interest rate announcements per year. Variable rates are cheaper than fixed rates and are shown as “prime minus X,” where X is your discount. Your discount will remain the same for the length of your term, but when prime changes, your total interest rate will change with it.
It may seem counter intuitive, but variable rates are actually safer to pick after a rate increase. That’s because the higher interest rates go, the more likely it is for them to have to drop again. Interest rates have already gone up 4 times since July 2017, with another one probably coming in a month. We’re getting closer to a tipping point: when that is exactly, no one knows.
If you got a 5-year variable rate in January 2017, before those rate increases, you would have gotten a rate of 1.87%. A 5-year fixed mortgage from the same time would have had a rate of 2.29%. Now, that variable mortgage would have a rate of 2.87%, which is higher than the fixed rate. On a mortgage balance of $300,000, the variable monthly payment works out to be $90 more per month than the fixed, or $1,080 per year.
However, if the fixed mortgage holder has to break their mortgage, they could lose those savings to penalties. So long as they’re able to stay for the length of their term, they’ll come out ahead.
The vast majority of terms in Canada last for 5 years. That doesn’t mean you should necessarily choose a 5-year term, but they are popular for a reason. Longer terms are more expensive (with 5-year terms being slightly cheaper than 4-year) and fixed rates are more expensive than variable.
If you choose a shorter-term mortgage because you want a lower rate, you may have to renew in the face of higher interest rates, negating the benefit of a shorter term. On the other hand, if you get a longer, more expensive term and rates don’t surpass it, then you would have spent extra money for nothing.
5 years is a good middle ground if you don’t have any specific plans for your building beyond “I plan on living here for the foreseeable future.” If you plan on selling or moving at a specific time, it can be better to choose a shorter option.