Fixed or Variable? The Question People Love to AskMarch 31, 2010
Readvanceables – How to Make Your Own MortgageApril 9, 2010
After ten years in the mortgage business, much of it spent designing the mortgage products that you may be considering today, I can unequivocally state that the five-year fixed-rate mortgage product is overrated. It is the Beta to our VHS, the Walkman to our iPod, the analog to our digital. Like a Swiss army knife that does a little bit of everything but nothing well, the five-year product gives you a little interest-rate protection, but not much else. So why do the majority of Canadians still choose a five-year fixed-rate mortgage product? We’ll get to that in a minute, but first let’s talk about you, the borrower.
Each borrower’s decision about whether to choose a fixed or variable product is primarily governed by either fear or greed (the fear of rising rates versus the greed of not wanting to pay anything more than the lowest possible rate). For an detailed explanation of this truism check out my post called Fixed or Variable: The Question People Love to Ask. Borrowers who are governed by fear want interest rate predictability, but does a five-year fixed term really give you that much protection? If inflation kicks into high gear and rates start going up quickly, the time remaining on a five-year term runs out pretty fast. Many other products offer you more flexibility and/or protection than a standard five-year fixed-rate mortgage does. So back to the question you’re probably dying to ask. “If the five-year mortgage is overrated, why are the majority of Canadians still choosing it?”
Let’s turn the tables for a minute and look at the product spectrum from a lender’s perspective. When you’re in the lending business, issuing short-term money is a tough gig. You make less money per dollar lent, your customers can break their mortgage for a lower penalty, and if rates go up and they can’t handle the shock of higher payments, your defaults will start going through the roof.
Lending out long-term money (more than five years) is also less attractive because the bank has to wait a long time to get it back, and if a borrower’s circumstances deteriorate, there is no way to reprice the credit risk until the term expires. From a funding perspective, banks use the swap market to hedge their interest rates. Five-year mortgages can be easily matched with five-year Government of Canada bonds, which are plentiful. Longer mortgage terms are harder and more costly to hedge because the swap market gets thinner beyond five years. What’s more, after the first five years of any mortgage term, the Interest Rate Act mandates that payout penalties cannot exceed three-months worth of interest due, which is far less than can be charged on a five-year fixed-rate term. Without an onerous payout penalty to keep borrowers locked-in, the banks are less able to predict how long these loans will actually stay on their books.
If you asked bankers to describe their perfect mortgage product, they would have customers paying locked-in rates for the maximum period in which they could charge a substantial payout penalty (five years). They’d also want the option of re-evaluating each borrower’s credit worthiness sooner rather than later and they wouldn’t want to pay the higher hedging costs associated with mortgage terms longer than five years. Hmmm…a fixed five-year loan sure ticks all of their boxes, doesn’t it?
Thank goodness for free-market competition and the bounty of choice it affords consumers. If helping out your bank isn’t high on your priority list, check out my future posts to learn about products that will serve your needs a lot better than the banker’s favourite: five-year fixed-rate mortgages.