5-Year Fixed Mortgage Trap
The average Canadian wastes $22,000 after tax during their life for every $100,000 of their mortgage and takes 38 months longer to pay it off, according to a study by Moshe Milevsky.
This is because of taking 5-year fixed mortgages instead of variable.
They are marketed as being safe and a good protection against a sharp rise in interest rates.
The reality, though, is that they are nearly always a huge waste of money, because the interest rate is nearly always higher and you lose your negotiating power for five long years.
From 1975-2019, 1-year fixed mortgages saved money 100% of the time. 5-year fixed will probably save money for 5 years starting 2020-22, but it may be decades until next time.
That is why we call it the “5-Year Fixed Mortgage Trap”.
Listen to my latest podcast episode to find out:
- Why people take 5-year mortgages.
- What you should do instead.
- Why being aware of your negotiating power is key.
You can also read an article I wrote back in April of 2010 for the Million Dollar Journey website called: “Avoid the 5-Year Fixed Mortgage Trap”. Click HERE to read the article…
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Thank you Ed,
That was the way I was leaning as well once I rechecked the numbers. I can save/invest the difference and will hopefully have a better idea of long term plans by spring – and hopefully things will have started to settle with inflation/rate increases. If I do decide to sell early it will still be a 3 months interest penalty – but at a lower rate. Since I don’t totally know if I will be in this property for 5 years, I think I’d rather get the savings now since I know there will be savings this year, and reevaluate the next step when it comes….I appreciate the response and insights.
Hi Tryn,
At your rate of 3.39% for 1 year, I would take it, as well. The variable quote you have of prime -1.05% is 3.65%, that will likely float up to 4.65% by the end of this year. Even if it start coming down next year, your average interest rate for the next 12 months is likely to be between 4.25-4.5%.
Your rate is a full 1% lower. which is significant.
Having the 1.05% discount from prime for 4 more years will likely save you roughly .25%/year. 4 years of .25% is also a 1% savings, so about the same as your savings now. The difference is that you have to wait 5 years to get the savings you can get in 1 year.
These are all estimates and could be wrong. These types of decisions are best based on the most likely scenario over the term of the mortgage and then doing the math.
For me, the 1-year 3.39% is better, but not be a lot over that nice variable rate.
Ed
Thanks Ed,
It is a difficult choice with no crystal ball! I’m not much of a gambler. I looked at the paperwork my lender sent me again and in fact they locked in more options than I originally thought. The 1yr fixed is actually 3.39 and a 2yr fixed 3.69, along with the variable prime-1.05. I wouldn’t do a fixed any longer that 2yrs (unless I had a 1.8% like a friend of mine snagged last November!). I don’t like giving up that 1.05 but the 3.39 looks real nice for the next year while we see what happens with the increases….and I sort out my life…..
Hi Tyrn,
Given the options you have, I would take the variable over the 1-year fixed at the quotes you have. Both are great rates today. The 1-year fixed will likely cost less over the next year than the variable quote you have. However, you would have that variable rate for 4 more years. In normal markets, the discount from prime is .75-.90%, so you are relatively likely to save .25% interest for the following 4 years. That is likely the most signficant factor here.
Today, it looks like interest rates will likely rise another .75% in September and then another .25% in December. After that, it’s much less clear an depends on whether and how soon inflation comes down. Most likely, interest rates will start declining next year and be back to today’s levels in 1-2 years.
Inflation should come down likely next year, which should lead to lower interest rates – as long as the Bank of Canada remains serious about inflation and does not get sidetracked thinking about a recession or unemployment.
We think very high interest rates like 10% are very unlikely.
Ed
Hi Rocky,
In general, it is almost always smarter to take a variable or short-term fixed mortgage. In the last 70 years, they have saved money over 5-year fixed almost 100% of the time. Loong-term fixed mortgages also put you at risk of a huge penalty if you ever want to refinance or sell your home.
The only exception is if you are confident that the variable and short-term fixed will cost more over the 5 years. We think that is unlikely today.
Today, a variable is about 4% (prime -.7%), a 1-year fixed is about 4.75% and a 5-year fixed is between 4.6% to 5.0%. It looks like interest rates will likely rise another .75% in September and then another .25% in December. After that, it’s much less clear an depends on whether and how soon inflation comes down. Most likely, interest rates will start declining next year and be back to today’s levels in 1-2 years.
In this scenario, it’s not obvious which option will cost less over 1 year and over 5 years, but we think the variable will most likely cost the least.
Many people feel safer with a 5-year fixed, since interest rates won’t rise, but in reality you are locking yourself into a jail. You probably pay more and there can be a huge penalty to get out of a 5-year fixed.
Inflation should come down likely next year, which should lead to lower interest rates – as long as the Bank of Canada remains serious about inflation and does not get sidetracked thinking about a recession or unemployment.
You should almost never take a long-term fixed, unless you are being well compensated with lower interst rates over 5 years.
Ed
Up for renewal and also struggling with which way to go. I am pre approved for 5 year variable prime-1.05% (currently 3.7) – with most certain increases in the next 1-2 years but who knows how many, and a through error, a 1 year fixed at 3.89 – though initial predictions that rates would settle in 2023 seem to be pushed to 2024 right now so renewal in 1 yr may bring even higher rates. 2 and 3 year fixed rates have significantly increased since my approval. I had been leaning variable as there is potential I could sell (or port to a different property with better rental streams) I can write off some of the interest as a partial rental but if house prices drop significantly I don’t really want to sell at a loss but don’t want to be paying 6% on my mortgage and I don’t think I could swing 10% with recent increased life expenses and decreased income – especially if I want to maintain decent investment contributions. . . .
Totally unknown at this point.. The ability to lock in at super low rates are gone !!! Now, IMO, it’s an unknown which way is best.
Do you think the variable still is better than fixed in July 2022 ? Or are we headed into an environment where fixed is starting to make more sense..?
Thanks very much
Usually, 5yr rates are more expensive, as it was in 2012…
Move forward to 2020, and the cheapest rates are 5yr, obtainable at rates near 2%.. Have your thoughts changed ?