3- year vs. 5-year Mortgage Terms

3- year vs. 5-year Mortgage Terms

By : Edi Marinescu

The debate between a 3-year mortgage term and a 5-year mortgage term has become a regular topic of conversation for those whose residential mortgages are up for renewal.

Canadians can choose terms varying in length from 6 months to 10 years for their residential properties. Based on data from the Canadian Association of Accredited Mortgage Professionals, about a fifth of Canada’s mortgage holders choose three-year terms. In this article we are going to investigate why the 3-year mortgage term is becoming more appealing to borrowers in our current fluctuating and unpredictable Real Estate market.

Plan ahead to get ahead

From a planning perspective, the 3-year mortgage term allows for flexibility when the market seems unstable and when long-term plans are difficult to follow. It is easier to pivot from a 3-year mortgage term than from a 5-year mortgage term.

By the same token, a 3-year mortgage term grants the borrower the stability of knowing that they could reconsider their options sooner than in a 5-year mortgage term according to market conditions and financial planning based on future predicted stability of the market.

In Canada, 3-year mortgage terms have become more expensive than 5-year mortgage terms soon after June of 2020 because the banks have also been anticipating higher levels of risk due to inflationary indicators and high demand for this specific mortgage type.

Lenders ensure their risk is accounted for as the next three years could present a wide variety of changes in the market according global conditions. For you, as a borrower, choosing a 3-year mortgage term could leave you exposed to an interest rate increase much sooner than in a 5-year mortgage term. This is due to the unpredictable nature of long-term interest rates foreshadowing. Your choice needs to make sense and fit in your long-term planning, regardless of what occurs in the market. This is one way to save yourself the time, energy, and money spent on your short-term actions.

The most common mortgage product

The 5-year mortgage term is the most common mortgage product in Canada. Banks promote this term length as payments are easily predictable and as competition is fierce among lenders for the lowest interest rate. Borrowers naturally tend to prefer this product due to the competitive low interest rates they have access to. Ironically, the lowest rate 5-year mortgage term contract could lack in prepayment privileges compared to a mortgage with a higher interest rate.

Before June of 2020, you would have paid a higher interest rate for a 5-year mortgage term and since our economy has been challenged by internal and external conditions, the reverse has become true. 5-year mortgage terms have become more attractive and their predictability encompassing 60 months makes it easier to budget for payments on a recurring basis both for the borrower as well as for the lender.

Lenders seek predictability and payment stability with their borrowers so when you sign up for a 5-year mortgage term, you are an ideal customer as the lender expects interest to be earned on time. Breaking the 5-year mortgage term ahead of time can trigger a hefty penalty depending on whether you have chosen a fixed or a variable interest rate for your residential mortgage.

Consider your options before deciding

The prepayment penalty, as is known in financing, is a penalty that is applied to your mortgage when you pay it off because you found a better mortgage product through your mortgage broker. If you do not currently work with a mortgage broker, contact us today and we will pair you with a knowledgeable broker who can explain this further for you and help you plan a roadmap to your financial freedom, however that may look for you.

One of the major risks of signing up for a 5-year mortgage term is breaking it off due to unforeseen circumstances. Life happens and plans change. You may require to sell your property, relocate, or switch your mortgage due to better market conditions. Be wary though.

The prepayment penalty can be one of two types, depending on how your mortgage is structured. It could be either the sum of three months of interest on the remaining mortgage amount you owe or the interest rate differential (known as IRD) which is a complex calculation depending on the type of lender you chose. More often than not, IRD is significantly higher than the 3-months of interest, sometimes by $20,000 more.

If you can make the time to prepare for your financial journey before you are pressured into a corner to make decisions, you can come out miles ahead of those who do not plan at all. Current market conditions are unpredictable as we are slowly entering a recession and it could serve you well to put things into perspective by looking at the bigger picture before committing to a 3-year or a 5-year mortgage term.

Contact us today and we would be glad to find you options for your investment plan.