Long Terms vs Short Terms and the Rate Shock Factor
2015-06-13 | 13:59:41
Remember the 10 year fixed 3.99% frenzy of about three years ago?! We sure do! We moved quite a few clients into a ten year mortgage at that time. The thought being that rates could not possibly get any lower, in order to protect our client’s from ‘rate shock’ we told them about the 10 year product. And a lot of our clients chose that option simply for the peace of mind of that fixed low rate. Now of course, looking back, that may not have made the most sense for every client, but the thought at that time of rates hitting the low we are currently in, was to be quite honest, laughable. Hindsight is always 20/20!
That being said, the decision to choose a long term versus a short term can be a very personal decision, what’s right for one person isn’t necessarily what feels right for another, it’s not always about the numbers. This Financial Post article has some interesting statistics regarding which terms Canadians are choosing. As you can see if you checked out the article, the five year fixed is still the golden boy of Canadian mortgages, but there does seems to be a starting trend to move towards those longer terms in this low rate environment.
During the last year we have taken the time to review our client’s current mortgages and find the situations where there are potential interest savings by switching out of that 10 year mortgage. For our more risk adverse clients, they choose to stay within their term as they love the comfort of long term consistency, despite the money they can save on interest by switching to a shorter term. But for others, the interest savings are worth switching for. We like to call these clients ‘risk aware’, as they are aware of the risk associated with today’s low rates but feel comfortable with their decision and the level of risk.
Now you may be asking, what is the risk? This takes us back to that ‘rate shock’ we mentioned earlier, what is it and why should you care about it? Well let’s look at it this way; most experts agree that we have finally hit the bottom, the point at which rates can simply not go any lower. I mean 2.54% (OAC, rate subject to change) on a five year fixed?! That’s practically free money, and for those who remember the rates of the nineties (17-21 %!!) it is pretty unbelievable. So, say we’ve hit the bottom and we can only go up, let’s look at a scenario:
Say you have a $300,000 mortgage at 2.54% making monthly payments, amortized over 25 years. Your monthly payment is $1,349.88 for the five year term and at maturity your balance is $254,118.16. You want to renew into another five year fixed mortgage. But it is five years later and those rates aren’t as low anymore, let’s make the future five year rate 4.64% (this is the current qualifying rate that must be used to qualify a borrower for a variable mortgage or a term less than five years). The new payments would be $1,620.84, so about $300 more than what you were paying even with a lower balance, this is a 20% increase to your payment. This is rate shock, for some people it is easy to weather and absorb that increase, and for others it can be detrimental to their budget, or their ability to service the mortgage.
Manulife Bank of Canada recently released the results of their 2015 Household Debt Survey in which they polled 2,372 Canadians across all provinces (for more information and the full results click here). The main focus of this poll was to get a picture of how Canadians are handling their debt levels and how those levels are affecting their ability to save for the future. They did, however, also touch on this subject of rate shock. In this poll Manulife found “that more than a third of homeowners surveyed would encounter financial difficulty if their mortgage payment increased by just 10 percent” (click here for the press release that contains this statistic). So say our conservative assumption is correct and rates rise by just under a quarter percentage per year for the next five years, based on that Manulife statistic this means that almost one third of Canadians would have trouble making the new payment. Which when you really think about it, is quite staggering.
We honestly cannot say that we know where rates are going to go in the future, we can make an educated guess and say that they have to go up, but as to how much and when? Your guess is as good as ours. If the last five years have taught us anything it is that there is no tried and true formula to predict future rates in our current economic environment, for example this year everyone was ready for the Bank of Canada to raise the key overnight rate, and what happened? They shocked EVERYONE by lowering it! So it comes down to this, remember that a decision between a long term vs a short term is much more than just rate predictions. While you do want to weigh where you think rates will go, you also want to analyze your own personal risk preferences AND your financial ability to weather a rise in rates. Talk to your mortgage professional and have them run the scenarios for you, make sure that whatever decision you do make, you’ve done the research (statistically, financially and personally) to ensure that you are comfortable with your decision regardless of what the future of interest rates holds.