5 year fixed mortgages are marketed as being safe, sensible and offering protection against possible rate increases in the future.
Many people like them because they offer a fixed rate over a longer period – which makes it easier to create a budget when moving into a new home because you can easily predict what your monthly expenses will be.
The reality is that they cost more, have huge penalties and are less flexible than variable, shorter term mortgages.
Variable Mortgages Have a Lower Penalty (And More Flexibility)
With a variable rate mortgage, a typical penalty is 3 months of interest based on the current amount owing. That means if you have a mortgage of $350,000 at current rates, the penalty would be approximately $3,000.
Related: How to Reduce Your Mortgage Penalty
With a fixed rate mortgage, the penalty depends on the fine print within the mortgage documents. Most fixed mortgages have a penalty of the greater of: the interest rate differential (difference between your mortgage rate and the current rate) multiplied by the current balance owing and the amount of time remaining on the mortgage or 3 months of interest – whichever is greater.
In most cases, the interest rate differential calculation creates a significantly higher penalty. The more time left on the mortgage, the higher the penalty would be.
I can remember when we bought our first home – the condo we still have as a rental property. Rates were high, and we were convinced that a 5 year fixed rate was the way to go. Our rate was 5.79% and within two years a variable rate was as low as 2%!
At that time the penalty to break the mortgage would have been $15,000 – which was calculated by the lender using the interest rate differential.
If we had a variable rate mortgage, the penalty would have been approximately $2,500 – a difference of almost $13,000.
More Negotiating Power with Short Terms
When I signed the papers for our 5 year fixed rate mortgage on the first home, it essentially signed away all my negotiating power for the next 5 years.
Sure, rates could have gone up and I would have looked like a genius for locking in the current rate (5.79% at that time).
Regardless of what happened to interest rates – I still lost my ability to renegotiate for 5 years.
The mortgage market is competitive, and lenders compete against one another to find quality, reputable clients.
I prefer shorter term mortgages because I like to have the ability to negotiate for a lower rate more often.
5 Year Fixed Rate Mortgages Are More Expensive
In most cases, a variable or shorter term mortgage will be at a lower rate than a 5 year fixed rate.
This is because a 5 year fixed rate gives you the safety and stability of having the same rate for 5 years – and you pay a steep price for that.
Currently, the 5 year fixed rate is 2.99% and a 5 year variable is 2.35%.
If you have a mortgage of $350,000, over 5 years you would pay $10,533 more with a 5 year fixed rate than a 5 year variable rate.
Numerous studies using historical lending data have shown that the 5 year mortgage is the most expensive option most of the time.
A study released in 2008 showed that homeowners who chose variable saved about $22,000 over a 15 year period.
Other studies have shown that the odds of saving money with a variable mortgage are approximately 89%.
I really wish I would have known that before we chose a 5 year mortgage on our first property – if we had chosen variable, we would have saved thousands.
My Current Strategy
We bought our house (our second property) almost two years ago and opted to go with a 3 year fixed rate. We chose this because we got a low rate (2.6%) and it was actually cheaper than the variable rate at the time.
When the mortgage comes up for renewal I will look at negotiating a low rate to make sure our interest costs stay low.
I may choose variable when it is up for renewal, but only if the variable rate is lower than fixed.
I’m willing to bet interest rates will eventually increase in the future from the historical lows, but with a variable rate mortgage I’d have the option to lock in before rates start to go up.
Regardless of variable or fixed – it’s highly unlikely we will sign another 5 year fixed rate again.
What’s your mortgage strategy? Do you prefer fixed or variable? Longer terms or shorter?