Deciding on a Mortgage
Deciding on a mortgage
It is generally less expensive to continually roll over a short-term mortgage than to commit to a long-term one
Eric Tyson and Tony Martin
Published on Tuesday, Feb. 02, 2010 1:04PM EST Last updated on Tuesday, Feb. 02, 2010 1:06PM EST
This is the sixth in a series of 10 excerpts from Investing for Canadians for Dummies.
Whether to go for a short- or long-term mortgage is an important decision in the real estate buying process. You need to weigh the pros and cons of each and decide what’s best for your situation before you go out to purchase real estate or refinance.
Unfortunately, too many people let their interest rate crystal ball dictate whether they should take a short- or long-term mortgage. For example, those who think interest rates can only go up find long-term mortgages attractive.
When many people are trying to decide between a short- and long-term mortgage, they focus on how much they can save over the next little while, and then factor in their sense of whether interest rates will rise in the future.
Much more important, though, is to get a sense of each option’s total cost over the full life of your loan. Several studies have assessed how homeowners would have fared if they either continually renewed a short-term mortgage or stuck with five-year terms. Going back to 1980 when short-term mortgages were first made available, the studies found that 85 to over 90 per cent of the time, the least expensive choice was to continually roll over a short-term mortgage.
In order for a series of short-term mortgages to cost more than a five-year term, interest rates over that time must rise enough so that the one-year rate increases beyond the five-year rate, and stays there for a good percentage of that time.
You also need to consider how comfortable you are with the extra uncertainty that choosing short-term mortgages brings.
How much of a gamble can you take with the size of your monthly mortgage payment? For example, if your job and income are unstable and you need to borrow an amount that stretches your monthly budget, you can’t afford much risk. If you’re in this situation, you may want to stick with a long-term mortgage.
If you’re in a position to take the financial risks associated with mortgage payments that may change every six months or year, you have a better chance of saving money with a shorter-term mortgage. Your interest rate starts lower and stays lower when the overall level of interest rates stays unchanged. Even if rates go up, there’s a good possibility they will come back down over the life of your loan. Sticking with your short-term mortgage for better and for worse will likely help you come out ahead in the long run.
A short-term mortgage makes more sense if you borrow less than you’re qualified for. Or perhaps you can save a sizable chunk – more than 10 per cent – of your monthly income. If your income significantly exceeds your spending patterns, you may feel less anxiety about fluctuating interest rates. If you do choose a short term, you may feel more financially secure if you have a hefty financial cushion (at least six months’ to as much as a year’s worth of expenses reserved) that you can access if rates go up.
Don’t take a short-term mortgage because the lower interest rate allows you to afford the property you want to buy (unless you’re absolutely certain your income will rise to meet possible future payment increases). Try setting your sights on a property you can afford to buy with a longer-term mortgage.
