A 5-Year Fixed May Be a Bad Idea!

Category: Education and Learning, Home Purchase,

A 5-Year Fixed May Be a Bad Idea!
Summary: Long-term mortgages have higher penalties than shorter term mortgages or variable mortgages, and these penalties would outweigh any benefit of refinancing to a lower rate in the future.

The term you choose right now will affect much more than your interest rate. A specific mortgage term, most importantly, will affect your prepayment penalty should you plan on refinancing when rates decrease. And yes, we all believe rates will decrease (and I’m hoping sooner rather than later).
Ok, so let’s do a simple break down on variable and fixed rates:

Variable Rates
You Get: Lowest Prepayment penalty (3-months interest).

Variable Rates
You Give Up: Rate certainty: interest rates can fluctuate and payments *may* fluctuate (some variable-rate payments are fixed, albeit with trigger rates possibility)

Fixed Rates
You Get: Rate certainty: interest and payment certainty.

Fixed Rates
You Give Up: Prepayment penalty certainty – Interest Rate Differential (IRD) may exceed 3-month interest.

So to summarize the above, if you pick rate certainty, you’re stuck with the possibility of a very large penalty if you break/prepay your mortgage entirely. On the flipside, if you choose variability in your mortgage, you will have a low penalty.

On fixed rates, The IRD, prepayment penalty, is charged to compensate a lender when they are required to re-lend mortgage funds that have been paid out prior to a term ending. I.e., if you prepay your entire mortgage, there’s a penalty. Yup, we all know that. But, there’s a little bit of a method to the madness.

Now, when paying out a mortgage, if the lowest penalty you can get is a 3-month interest penalty, when would the IRD penalty be large/punitive? The quickest, most accurate answer to this is that the further you are from the renewal date, the larger your penalty! In other words, if you break your 5-year mortgage in the first couple of years, you could have a really high penalty.

That’s not the full story, however. The second part of the story is that if you pay off your mortgage, and your rate is low compared with current rates, the lender will be happy because they can then turn around and re-lend your prepaid mortgage money at a higher rate. In this circumstance, the prepayment penalty would be low, or as high as a 3-month interest penalty.

However, if you pay off your mortgage when your rate is high, and rates have decreased, the lender “*would* have gotten more interest from you than from re-lending that money when rates are lower, and the prepayment penalty would reflect that fact. Basically, you could be penalized heavily in prepayment penalties due to paying off your mortgage early. The prepayment calculation here is called the Interest Rate Differential or IRD.

So, IRD penalties can be extremely high when:
1. You have a long time left on your mortgage, and
2. Rates have decreased from when you got your mortgage.

Below is a screenshot of one of the major bank’s IRD penalty calculations.
To explain the above, A, D, and E are easy. The problem comes with B/C… Banks provide a “discount” off their base rates to give you your rate. If rates are high, and you get a “deal,” your discount would be higher and your potential penalty in the above would be higher too.

Based on the above example, the penalty would be 9%! of a borrower’s mortgage. Holy heck!! A 3-month interest penalty would have been 2.25% of the mortgage.

I want to be frank here… I know how high IRD penalties can be. I personally paid an IRD penalty in 2020 when rates decreased due to Covid. I had a 3.74% rate and refinanced, after 1 year, into a 2.89% rate. My penalty, on appx. $900,000 was $27,000. A penalty of over 3% of your mortgage almost outweighs any benefit of refinancing. In my case, that ~1% change saved me $36,000 over 4 years so it made sense.. barely. I refinanced again later.
Potential Real World Example
Let’s say we get a 5-year fixed rate mortgage today at a major bank, and then we want to pay out the mortgage in 1 year due to rate decreases. *I can see this situation happening all too easily.

Potential Mortgage Details
A) Our current rate today: 5.74% (this provides for a discount of 1.35% as current posted rates are 7.09%)
B) Current rate less discount = 3.84% (5.19% – 1.35%)
(in 1 year, I’ve assumed the posted rate for a 4 year will be 5.19%)
C) Penalty Rate: 1.90% (5.74% – 3.84%)
D) Paying out $400,000
E) 48 months left
F) Penalty = (C x D x E) / 12 = $30,400 (1.9% x $400,000 x 48) / 12

The penalty here is 7.6% of the entire mortgage! A three month interest penalty  would have been 1.44% of the mortgage.

There moral of the story here is that borrowers should be very aware of the risks of choosing a long-term mortgage if they think that rates are going to come down and they want to benefit from switching to lower rates.

Fixed-rate mortgages are stacked against borrowers in this specific situation but are somewhat better with monoline lenders. Lenders like First National do not take into account a “posted rate” and “discount” and their penalty would have been $8,800 or 2.2% of the mortgage.
I personally believe that rates are going to come down. It behooves us to not just think about what the breakeven rate we would need to get if we were to choose a 3-year or a 5-year, or even a 2-year mortgage, we need to think about the possibility of breaking mortgages for better rates within the term… not to mention the need to sell a property; life happens!

Large penalties just suck, and lower term mortgages (2 and 3 years) and variable rate mortgages can bypass them. Again, this is especially the case while we’re at the above average rates we’re still seeing at this time.

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