Should you choose a five-year or three-year fixed-rate mortgage?

When it comes to choosing a fixed rate mortgage, the length of the term can make a big difference when it comes to your bigger financial picture. However, making the decision to choose a five-year fixed rate or a three-year fixed rate mortgage can be tough–so it's important to consider the pros and cons of each.

First off, what is a fixed rate mortgage?

A fixed rate mortgage is a type of home loan where the interest rate is fixed for the entire term of the mortgage. This means that your monthly mortgage payments will remain the same for the entire length of the term, regardless of any changes in the market’s interest rates.

What is a variable-rate mortgage?

A variable-rate mortgage is a type of home loan where the interest rate can fluctuate over the duration of the mortgage term. This means that your monthly mortgage payments can vary, adjusting in response to market interest rate changes. Unlike a fixed-rate mortgage, which offers predictability in monthly payments, a variable-rate mortgage provides the potential for lower interest costs when market rates decrease. Still, it also comes with the risk of higher payments should rates climb.

So why choose a fixed-rate mortgage?

When it comes to choosing between a fixed-rate and variable-rate mortgage in Canada, there are a few things to keep in mind. One of the main things to consider is the prime rate, which is affected by the Bank of Canada. If you go with a variable-rate mortgage, your monthly payments will change based on the prime rate the Bank of Canada sets, which can be a bit of a gamble. 

The Bank of Canada has adjusted the prime rate 14 times in the last decade, influencing both fixed and variable mortgage rates. But if you go with a fixed-rate mortgage, you'll have the same interest rate for the entire term, so you won't have to worry about surprises. And hey, if you're someone who likes to play it safe, a fixed-rate mortgage can be a great option because you'll have a steady payment plan, regardless of whether the prime rate goes up or down. In a survey, 67% of respondents cited the predictability of payments as the primary reason for choosing a fixed-rate mortgage.

Why do we not have 30-year fixed rate mortgages in Canada?

Americans are able to lock in interest rates for the amortization of their mortgage for up to 25 and 30 years. However, in Canada, we are able to only lock in a fixed rate for 5 years typically. This seems largely lender friendly rather than consumer friendly. Why is that case? Why won't banks offer longer terms? One of the main reasons banks are not willing to assume the risk of a longer fixed rate term is because of the Interest Act. Section 10(1) can basically be summarized as restricting banks on penalties they can charge customers for breaking a mortgage term over 5 years to only 3 months of interest after 5 years have passed. Banks have very little recourse for the cancellation for longer term mortgages, meaning they take all the downside risk and not much of the upside reward. If rates go lower, people will break to get a lower rate with little penalty, while they will stay on the original mortgage if rates were to go up. The Interest Act has been a pivotal regulation in Canada for over 100 years, shaping the mortgage landscape and protecting consumers from exorbitant penalties.

What percent of Canadians have chosen a three-year fixed

In 2020, nearly half of the mortgages, approximately 49%, had a five-year fixed rate. However, a dramatic shift occurred within the past year as the Bank of Canada increased its policy interest rate from 0.25% in February 2022 to a staggering 4.50% by January 2023. As a consequence, mortgage rates also climbed, prompting Canadians to gravitate towards shorter mortgage terms, offering more affordable rates, to secure their ideal residences. In June 2023 Statistics Canada reported that chartered banks advanced $8.2 billion in funds towards residential mortgages that were insured by mortgage insurance. Of that amount, $3.7 billion were 3 or 4 year term and $1.9 billion were for terms 5 years or higher. This means that generally, Canadians that got their mortgages from chartered banks chose a 3 to 4 year term 45.4% of the time, while they chose a 5 year or higher term only 22.7% of the time. In June 2023, Canadians choosing a 3 to 4 year term for their mortgages from chartered banks was double (45.4%) the number choosing a 5 year or higher term (22.7%). Chartered banks advanced $39.5 billion in funds for the uninsured side of mortgages in June. Of that, $21 billion was towards mortgages with terms that were 3 or 4 years. $3.9 billion was advanced for mortgage terms 5 years and up. This means that for Canadians who got an uninsured mortgage from chartered banks in June, 53.3% took a 3 or 4 year term and only 9.8% took a 5 year or higher term. From these statistics, it becomes clear that Canadians prefer a shorter 3 year mortgage term to a 5 year term in the current rising rate environment. The assumption is that, they believe that the mortgage rates will improve (become lower) when they renew in 3 years as compared to the rates that they have locked in for. Whether that is right or wrong will be decided in the future by the Bank of Canada and the economy.

Why choose a five-year fixed rate mortgage

Often touted as the granddaddy of mortgage terms, a five-year fixed rate mortgage is a popular option among home buyers. Considered the standard for most mortgage products and is often the most advertised rate, the main benefit of a five-year fixed rate mortgage is the stability it provides. Advertisements for five-year fixed-rate mortgages are 60% more prevalent than those for other mortgage terms, reflecting its popularity and standard status in the industry.

Pros of a five-year fixed rate mortgage

1. Rate stability: A five-year fixed rate mortgage provides rate stability and predictability. You'll know exactly how much your mortgage payments will be for the next five years, which can make it easier to budget your finances.
2. Peace of mind: A five-year fixed rate mortgage can provide peace of mind, knowing that you have a predictable mortgage payment that won't fluctuate with interest rate changes. If you plan to stay in your home for the foreseeable future, this is a great benefit to a longer-term mortgage. 
3. Lower interest rate: A five-year fixed rate mortgage typically comes with a lower interest rate than a shorter-term fixed-rate mortgage, which can save you money over the long term.

Cons of a five-year fixed rate mortgage

1. Higher penalties for early termination: If you need to break your mortgage early, the penalties can be significant. Numerous sensational stories have emerged about homeowners hit with hefty "interest rate differential" (IRD) penalties, sometimes exceeding tens of thousands, for terminating their mortgages prematurely. Essentially, this penalty compensates for the lender's potential losses when you end the contract early. However, this is more palatable than the substantial IRD fees from major banks, which could escalate to $10k, $20k, or even higher, based on the loan's size and interest rates. With a five-year fixed-rate mortgage, the penalties are typically higher than those for shorter-term mortgages.
2. Potential to miss out on lower rates: If interest rates go down, you won't benefit from the lower rates until your five-year term is up. This can be frustrating if you see other homeowners getting lower rates.
3. Longer commitment: A five-year fixed rate mortgage is a longer-term commitment, which means that you're locked in to the mortgage rate for a longer period of time. If you anticipate that you might want to move or refinance your mortgage within the next five years, a shorter-term mortgage may be a better option.

Choosing a three-year fixed rate mortgage

Overall, a three year-fixed option provides the same stability as a five-year fixed rate mortgage, but for a shorter period of time. And while a three-year fixed mortgage isn’t as common, according to recent data from CMHC, 28% of Canadians opted for a one- to three-year fixed rate mortgage. 

Pros of a three-year fixed rate mortgage

1. Lower penalties for early termination: If you need to break your mortgage early, the penalties for doing so are typically lower than those for longer-term mortgages. This can be an important consideration if you plan on moving or refinancing within the next few years.
2. Flexibility: Connected to the fact there are lower penalties for breaking your mortgage, a three-year fixed-rate mortgage provides more flexibility than a longer-term mortgage. After three years, if your current lender isn't cooperative, you have the freedom to change lenders to secure a better offer. It’s a good option if you're uncertain about your plans and want to keep your options open.‍
3. Potential to take advantage of lower rates: If the interest rates drop during your three-year period, given your term ends after a shorter time, you have the potential to take advantage of lower interest rates sooner than you would with a longer-term mortgage.

Cons of a three-year fixed rate mortgage

1. Less rate stability: A three-year fixed rate mortgage provides less stability and predictability than a longer-term mortgage. If interest rates rise, your monthly mortgage payment could go up by when it’s time to renew your mortgage.
2. Potentially higher interest rates: A three-year fixed rate mortgage typically comes with a higher interest rate than a longer-term mortgage, which can result in higher monthly mortgage payments.
3. More frequent renewal: With a three-year fixed rate mortgage, you'll need to renew your mortgage more frequently, which can be a hassle and may result in additional costs, such as appraisal and legal fees.

So, which option is right for you?

Choosing between a five-year fixed rate and a three-year fixed rate mortgage all depends on your personal circumstances and financial goals. If you value stability and predictability, a five-year fixed rate mortgage may be the right choice for you. However, if you want more flexibility and the potential to take advantage of lower interest rates, sooner than later, a three-year fixed rate mortgage may be a better option.

It's important to remember that mortgage rates can change rapidly and unexpectedly, so it's important to work with a knowledgeable mortgage broker who can help you navigate the market and choose the right mortgage product for your needs. Be sure to shop around and compare rates from different lenders to ensure that you're getting the best deal possible.

And if you’re ready to start your home buying journey, apply with Pine today and we’ll connect you with one of our mortgage agents to answer any and all your questions.