Which Term is Best?

June 10, 2013

You have two choices when choosing a mortgage term:

  • Short-term rate protection, i.e., a:
    ■  Variable rate
    ■  6-month fixed
    ■  1-year fixed
    ■  2-year fixed
  • Long-term rate protection, i.e., a:
    ■  3-year fixed
    ■  4-year fixed
    ■  5-year fixed
    ■  6- to 10-year fixed

Whether you go short-term or long-term depends largely on 5 things:

1)  Your ability to financially handle rate increases

  • Can you withstand a 2-3 percentage point rate hike
    ■  Rate hikes could happen during your term (if you take a variable) and at renewal
    ■  A 2-3 percentage point hike could increase your payments roughly 24-37%
  • Do you have stable employment and income?
    ■  The risk of higher payments increases if your income might drop
  • For more, see “I.D.E.A.S. for choosing fixed vs. variable

2) Your faith in the past

  • Shorter-terms have proven less costly the majority of time, historically
  • Rates go up and down in cycles, and when they increase, they don’t increase forever

3) Your psychological risk tolerance

  • If rates start increasing every few months will you panic and lock into a high fixed rate?
    ■  You will virtually never get the best rates at the time you lock in
    ■  Successfully timing interest rates is practically impossible
    ■  If you plan to eventually lock in, you’re usually better off with a fixed rate from the start

4) The spread between short-term and long-term rates

  • Your odds of success with a longer term are arguably higher if:
    ■  The spread between long and short-term rates is small (e.g., less than one percentage point)
    ■  Rates are in a cyclical trough

5) The likelihood of you needing to refinance

  • Breaking a closed mortgage early entails penalties
  • If there is a chance you’ll need to renegotiate your mortgage in the next 1-3 years, a longer term may not be appropriate
  • Common reasons to break a mortgage early include the need to:
    ■  Sell your home
    ■  Refinance into a lower rate
    ■  Borrow more money (e.g., increase your mortgage to pay off debt, start a business, fund education, etc.)
  • Note: With a longer term, you can often port your mortgage to a new property or blend the rate (if you request more money), but then you’re stuck with whatever terms the lender gives you. If the lender knows you’ll pay a penalty to leave, it might not negotiate with you.