It seems that the five-year fixed mortgage is the Holy Grail of mortgages – a reasonable rate, steady payments, long-term peace of mind… What could be wrong with that?
Well, perhaps one’s personal preference really is to have a five-year fixed mortgage, or perhaps the new CMHC regulations have forced this particular product as the only reasonable option (an increasing issue in Vancouver, Calgary, and Toronto).
Whichever is the case, it is important to note that there is risk posed by such a longer term commitment – and there is a key step to mitigate that one particular facet within the five-year fixed-rate product. Lender selection is the key.
So what’s the risk? Specifically, the methodology of calculating prepayment penalty, an important topic touched on in the past here, here, and here.
Over the past few years in particular, very few five-year fixed mortgage penalties have been calculated with the perceived standard three months' interest rule. Instead the Interest Rate Differential (IRD) has been used as a tool of destruction, costing many Canadians additional thousands, sometimes of tens of thousands, with its weak logic tilted toward the pockets of the lenders’ shareholders.
Let’s take a look at a recent client’s mortgage balance of $300,000.00 and the impact their choice between lender may have, should they fall into the six in 10 CDN’s that find themselves triggering a prepayment penalty.
For our purposes, we will use the statistical average of 38 months as our penalty trigger point. It’s worth noting that we are effectively projecting 38 months into the future and using today’s rates to calculate the penalty. However all it takes are low short-term (i.e. two-year fixed) rates to make this reality, as longer-term (i.e. five-year fixed) rates are not a component of the calculation.
So, 38 months into a 2.89 per cent five-year fixed rate mortgage, having made monthly payments of $1,244.32, the balance for penalty calculation will be $279,095.57.
Big Banks penalty Calculator shows a prepayment penalty of $6,344.77
With a projected renewal date of 08/2016 in our example:
Mortgage Lender Calculator shows a prepayment penalty of $2,016.47
The two companies share near identical lump sum payment and frequency of payment privileges, both are Canadian owned, each have excellent customer service standards. They are arguably as similar as Coke and Pepsi.
There are several other facets around the issues of penalty calculations, and the various triggers, many of which are far from obvious and certainly not top of mind when in the throes of negotiating your first mortgage. Slow down and have a conversation about the “what-ifs” of how your life might change in the five years of your mortgage term.
A few examples of how these penalties are triggered:
- Marriage (each owns their own property, now they have one too many)
- Children (their arrival is sometimes unplanned, and sometimes in pairs)
- Adult children (one day they leave, and now the house is too big so you downsize right out of a mortgage altogether)
- Work (transferred out of province? Not great if in a Credit Union mortgage)
- Business (refinancing to start, grow or bail out a business)
- Divorce (neither party can retain the current residence on their own)
If, as current statistics suggest, the five-year fixed product does not work for six out of 10 borrowers, why is it still so heavily promoted?
The reasoning behind the marketing of any product is rarely linked to it being “safest” or “best” for the consumer, rather it has to do with economics.Most heavily advertised is usually directly linked to most profitable, which accordingly generates a correspondingly larger advertising budget.
Significantly more money is spent advertising soft drinks than say tap water, but which one is the better choice for the consumer at any point in the day? Always question whether you are choosing solutions that are the best fit for you or best for the provider.
Speak at length with your broker about the potential shifts in your own life in order to set out the best plan.
