When it comes to picking the type of mortgage and term, there are several factors to consider. Most 5 year fixed mortgages are broken at 38 months resulting in potentially large pre-payment penalties. It is sometimes difficult to predict where you will be in 5 years. A job transfer, the need to refinance, there are many reasons why mortgages are broken before the end of the term.
What can you do to avoid these large pre-payment penalties? If you are set on having a fixed mortgage product, then you may want to consider going with a 1, 2, or 3 year term. Shorter terms give you the flexibility to make changes without incurring large mortgage penalties. A 5 year fixed term is great if you know for certain that you will not need to refinance or change your mortgage.
A variable rate mortgages offers some great advantages over a fixed rate mortgage. Historically, variable rate mortgages perform better than fixed rate mortgages. In addition, the penalties associated with variable rate mortgages are lower than fixed rate mortgages. Typically, variable rate mortgages have a three month interest penalty. A fixed rate mortgage, by contrast, uses the higher of a three month interest penalty or the Interest Rate Differential (“IRD”) which is usually substantially higher depending on when you break the mortgage contract. There is no standard formula for calculating the IRD. Each lender has their own method for the calculation.
With a variable rate mortgage, you can “lock in” to a fixed rate usually without penalty, provided you lock in with the same lender for a term that is longer than the remaining term of the variable rate mortgage. For example, if you have a 5 year variable rate mortgage with 2 ½ years remaining, you could lock in at the 3 year fixed rate and have the penalty waived.
It is important to understand the terms and conditions of the mortgage product you select. A mortgage broker can help explain the advantages and disadvantages of various mortgage products.