I have often wondered why so many people opt for 5 year fixed rate mortgages. Yes, they want the security of knowing exactly what their payments are going to be over those 5 years but they sure are paying through the nose for that security. As I write this, interest rates on a 5 year closed variable rate mortgage are 4.15%. Take that instead to a fixed 5 year closed mortgage and you are looking at 5.65% or more. Yes, a whole extra 1.5 points for the privilege of knowing what your payments are going to be over those 5 years. Essentially you are buying an insurance product. 1.5/4.15 x 100 = 36% . Yes, you get to pay 36% more interest in order to cover your "insurance" premium. So just how much is that? On a $200,000 mortgage, that 1.5% extra interest = $3000 per year. Over 5 years, that is close to an additional $15,000 assuming interest rates don't change and ignoring principal reduction. You're effectively giving up a new car every five years!!!
But of course interest rates don't stay unchanged, they could go shooting way up. Sure, but they could also go down too. So why does anybody go with the 5 year fixed? Simple, because somebody convinced them that they could get screwed and not be able to make their mortgage payments if interest rates go shooting up. Fear can be quite the motivator. But there is a feature of most variable rate mortgages that they don't want you to know about. Most of them allow you to convert them to a fixed rate mortgage at any time. So if interest rates start to rise and your payments on your variable rate mortgage jump up and you get all scared, then simply convert it to fixed. But there is another tactic that I'd rather you use.
Take out a variable rate five year mortgage, but at the same time ask them to tell you what your payments would have been if you had've taken out the five year fixed. You are effectively going to insure yourself with this scheme. Take the difference between your mortgage payments and the hypothetical fixed rate payment, and place that amount into a savings account. In fact, place it into a new Canadian tax free saving account (TFSA) that becomes available to us taxpayers on Jan. 1, 2009. This amount, of course, depends on the size of your mortgage and the difference between the variable and fixed mortgage rates, but could easily be around $125 per month for many of you. As interest rates fluctuate, so will your payments into this account. If your payments ever reach the point where they exceed the hypothetical five year fixed payments, then simply draw money out of the account to cover the difference. At the end of the five years, when your mortgage now needs to be renewed, simply liquidate your savings account and put that extra money down on the mortgage. Alternately you could use this money to top up your RRSP and put the tax refund against the mortgage. But in either case you should be immensely better off by using this do-it-yourself approach to a "five year fixed" mortgage rather than the bank's conventional way of simply charging you a much higher fixed rate.