Tuesday, July 25, 2017 00:28

Will A 10 Year Term Save You Money?

Tax-Savings

The best rate will save you hundreds but the wrong term can cost you thousands

While it’s great to know you are getting the lowest rate out there, too often people are overly focused on finding the lowest rate without realizing that the wrong term can be significantly more expensive.

The 10 year mortgage is a perfect example of how selecting the wrong term can cost you.

It doesn’t happen often, but every now and again mortgage customers inquire about a 10 year term. Thanks largely in part to the record low interest rates and the inevitability or rates increasing some consumers are being drawn to the longer terms.

The 10 year mortgage gives you the ultimate in risk aversion. A 10 year term affords you the comfort of knowing your exact mortgage payment for a decade. While others ride the interest rate roller coaster you are safe from any change to your rate.

This security comes at a price though.

Mortgage Rates are based on the risk that they pose to the lender. In the simplest terms the longer you want the security of knowing your interest rate, the more you have to pay the lender.

Anecdotal evidence suggests that a 10 year term is historically offered at a premium of 1.25% more than the 5 year term – the most popular mortgage term in Canada.

While we know that you pay a premium for a 10 year term under the auspice that it will protect you in the future. I took a look at how much that extra security will cost you in the short term, and also, how many times that added security has paid off in the past 25 years.

For the purposes of the following examples we will use a difference of 1.00% between the 5 year rate and the 10 year rate. This is for simplicity sake and also provides a very conservative result.

(Note: Recent synopsis of Lenders rate sheets reflects 1.00% as the average difference between 5 and 10 year terms)

Is paying a premium for the 10 year term worth it? Let’s start by looking at the short term costs of going with a 10 year term.

First we will compare two consecutive 5 year terms with the 10 year term to determine the associated interest costs.

By comparing a 5 year fixed rate at 4.00% and the 10 year fixed rate at 5.00% we are able to determine that for every $100,000 of mortgage, you will pay an additional $4788 in interest over the first 5 years of the 10 year term.

This is a significant cost to pay for the added security of the additional 5 years.

Operating on the assumption that your first five year term has an interest rate of 4.00% amortized over 25 years then your 2nd 5 year term would need to increase  by roughly 2.25% in order for the interest paid between the 2 terms to equal the interest you pay on the 10 year term.

Make sense? Let’s look at it this way.

  • The total interest paid over  10 years at 5% would be $43,588
  • If you were to go with a 5 year fixed rate at 4.00% with the same amortization and mortgage amount you would be paying $18,615 in interest   over   the first 5 years.
  • In order for the 10 year term to save you money, a corresponding new 5 year fixed rate would need to cost $24,973 in interest over the final 5 years.

This corresponds to an interest rate of around 6.25% which will cost $24,996 in interest over the final 5 years.

As you can see by using a conservative 1.00% difference between the 5 year and 10 year rates you would need to hope that an increase of over 2% occurs in order for the 10 year option to be beneficial.

As we can see you are paying a considerable premium when going with a 10 year term. This is all based on the presumption that interest rates will climb and you will be protected in 5 years time.

How many times in the past 25 years has the 10 year rate been more affordable than two consecutive 5 year rates? Let’s take a look!

To determine the historical numbers I undertook the following calculations:

  • I compiled the average Chartered Bank 5 year mortgage rates from January 1980 until December 2010 as offered by the Bank Of Canada
  • Next I added a 1.00% premium to the 5 year rates to come up with estimated rates for 10 year terms.
  • Finally I used the 10 year rates and compared them to the average 5 year rates, 5 years after origination of the 10 year rate.

The results showed that in the 300 months used as comparables the 10 year rate was lower than the corresponding 5 year renewal rate only 8 times.

It is important to note that in NONE of these 8 occurrences was the difference between rates large enough to create an actual savings for the 10 year term.

Some may point out that the 1980s are not an ideal period to provide comparable historical data due to rampant inflation. Even if we look at the numbers after 1991 when the Bank of Canada adopted its inflation targets there was only a single instance where the 5 year rate exceeded the 10 year comparable.

While this example is by no means a scientific study, it does show how infrequently the 10 year rate beats 2 consecutive 5 year rates.

Needless to say our current interest rate climate begs the question, Is this one of the 3 times out of 100 in the last 25 years that a 10 year will come out on top?

*One item of note with 10 year terms is that as a result of the Interest Act you can get out of your mortgage with only 3 months interest after 5 years. However why pay the premium in the first five years if this is something you would consider?

John Shearer
@GTAMortgageNews

John Shearer is a Mortgage Agent who can be found helping first time home buyers at www.MyNewMortgage.ca and on his blog at www.OntarioMortgageDeals.com