Friday, March 29th, 2019
When shopping for a mortgage, many borrowers focus on finding the lowest interest rate. After all, the amount you'll pay monthly has a direct impact on your financial bottom line, and the size of your home buying budget.
However, it shouldn't be your only consideration. Selecting the right mortgage term — the length of your mortgage agreement — will have an even greater impact on your home costs over time.
The mortgage term is an agreement that establishes the interest rate, as well as the other included mortgage features, over a set period of time. It's not to be confused with the mortgage amortization, which is the total length of time it'll take to pay the mortgage off in full (currently a maximum of 25 years for homebuyers who put less than 20% down, and 30 years for those over that threshold).
A number of mortgage terms will be set over the course of the amortization. When your term ends, you'll need to negotiate another, and your interest rate may change at this time, based on what the lender's current rates are at the time, your standing as a borrower and the state of your finances.
Because you could be facing a higher rate when you renew your term, it's important to choose a mortgage term that suits your risk tolerance and aligns with your long-term plan. Mortgage terms range from as short as six months to as long as 10 years. Anything beyond a four years is considered a "long-term" mortgage.
Five year terms are the most popular in Canada. Considered the "Goldilocks" of mortgages, they offer just the right amount of stability over time, with the ability to switch up your rate and features over the medium term. However, there are reasons to consider taking out a much shorter or longer term. Here's a look at the why:
Generally, the shorter the mortgage term, the lower the interest rate. People who want to lock in over an extended period of time will pay a premium for that stability. For example, rates for 10 year fixed terms can range between 1-3% higher than a five year option. That can make a big difference in affordability when perusing Toronto real estate listings or Vancouver homes for sale.
The main motivation for choosing a long-term mortgage is financial certainty. You'll know exactly what your mortgage payment will be over an extended period of time and that it will not change during that time as a result of changes in the economy.
Long-term mortgages also provide cover during times of household financial transition. If the factors that qualify you as a borrower change, such as a spouse leaving the workforce or pursuing a new career, you won't need to worry that it could impact your re-qualification at renewal, as it could with a shorter mortgage term.
However, that comes at the cost of flexibility. If you need to break your mortgage before your term is up, or if you'd like to switch to a product with a lower rate, the associated prepayment charge – for fixed closed term mortgages, the higher of three months' worth of interest or the interest-rate differential amount – can be significantly higher with a longer term. For this reason, it's important to ensure that your longer-term mortgage has features like the ability to port your mortgage from one property to another if you move, and the option to accelerate payments or put down a lump sum prepayments up to a certain percent.
Locking into a shorter-term mortgage means less commitment, but it'll also expose you to changes in the marketplace. For example, if interest rates spike over the following year, you could be in for sticker shock at renewal time. You'll also need to face the hassle of renegotiating your mortgage more frequently, which can be detrimental if your financial health changes in the short term.
However, if you know you'll need mortgage flexibility due to an upcoming life change, shorter terms can be a great option. If you need to break your term, the prepayment charge can be lower.
Short-term mortgages can also be a helpful tool in improving your credit score and qualifying for an even better rate later on. Successfully paying the mortgage and fulfilling the shorter term can help your credit, and is a common way to help many borrowers get on the property ladder.
Knowing what life's circumstances may be 5 to 10 years down the road may be like peering into a crystal ball. That's why it's a great idea to connect with a mortgage advisor to discuss your short-term and long-term plans and determine how your mortgage term could support those goals.