Buying a home is full of many exciting and pivotal decisions. For instance, you’ll need to decide which house is right for you, how much you can afford to spend, what city to live in, and where to get your mortgage. Once you have a signed offer and are under contract for your home, you must finalize your mortgage. You probably know that you should shop around for the best mortgage rate, but do you know what mortgage term is best for you?
For many years, a five-year fixed-rate mortgage term was the most popular option for Canadians.
In 2020, about 49% of mortgages were five-year fixed-rate mortgages. But over the past year, the Bank of Canada has raised the policy interest rate significantly, from 0.25% in February 2022, to 4.50% in January 2023. Mortgage rates followed suit, which has caused Canadians to choose shorter mortgage terms with lower mortgage rates to afford their dream homes. As a result, today’s higher interest rates and the potential for lowered interest rates in 2024 and beyond mean that a five-year fixed-rate mortgage is no longer the default choice.
If you aren’t sure which mortgage is right for you or even what a mortgage term is, keep reading for everything you need to know.
What is a Mortgage Term?
Your mortgage’s term is the length of time your mortgage contract is set with your lender. Terms can range from a few months to five years or longer, but the most popular term lengths are two, three, and five years.
The term includes everything outlined in your mortgage contract, including your:
- Mortgage interest rate
- Monthly payment amount
- Prepayment privileges
- Penalties for breaking the term early
You’ll choose a mortgage term when finalizing your home purchase financing after you have an accepted offer to purchase but before the closing date.
When your mortgage term ends, you can renew your mortgage term with your lender or shop around and get a new mortgage with another lender. At the end of your term, everything in your contract is up for negotiation again, including your interest rate, monthly payments, and the length of your new term.
Term vs Amortization
Mortgage terms are often confused with mortgage amortizations, but the two are entirely different aspects of your mortgage. Here are the key differences:
Fixed vs Variable Mortgage Terms
When choosing your mortgage term, you are choosing the length of time that your mortgage contract with your lender lasts. So how do the terms “variable” and “fixed” factor into this equation?
Variable and fixed mortgage terms refer to the interest rate of your mortgage. So when you hear the phrase “five-year fixed rate mortgage,” you choose a fixed interest rate for five years. Similarly, a “three-year variable rate mortgage” means you are choosing a variable mortgage rate for three years.
A fixed-rate mortgage means that the interest rate will not change during the term, regardless of whether industry mortgage rates fluctuate up or down. Fixed-rate mortgages are a good choice for homebuyers who want the predictability of a monthly locked-in mortgage payment.
Variable-rate mortgages fluctuate as the Bank of Canada’s policy rate (and, therefore, the lender’s prime rate) fluctuates. For example, you may choose a prime + 1.0% variable rate. In that case, your rate will always be 1% more than the prime rate for your entire mortgage term. Variable-rate mortgages are riskier for homeowners because the interest rate can rise and fall. The overall effective interest rates tend to be lower than a fixed-rate mortgage.
Should You Choose a 5-Year Mortgage Term?
Choosing the right mortgage term depends on your financial situation, goals, and risk tolerance. Five-year fixed-rate mortgages, for example, give homeowners certainty about their mortgage rate (and monthly payments) for at least five years, and that peace of mind led to its popularity. Unfortunately, that peace of mind comes at a price, and five-year mortgages tend to have higher mortgage rates.
Here’s what to consider if you think a five-year term is right for you:
First, consider your plans for your home. Is it a home you plan to live in for at least five years? Ending your mortgage term early can result in expensive penalties, so if you plan to move within five years, it’s best to choose a shorter term.
Second, consider the mortgage rate your lender offers for a five-year mortgage. A higher mortgage rate translates into a higher monthly payment. If you think rates will fall within the next five years (and some experts have said this is likely), you may end up paying a higher mortgage payment for longer than necessary.
Should You Choose a 3-Year Mortgage Term?
A shorter mortgage term gives you less certainty about the rate you’ll pay but has the benefit of flexibility. If you aren’t sure whether your money, job, or living situation will change in the next five years, a shorter term could be a better option.
Shorter mortgage terms aren’t as expensive if you need to break the mortgage contract early, a penalty that could otherwise cost you tens of thousands of dollars.
Shorter mortgages traditionally give you access to lower mortgage rates because they are less risky for the lender (since they aren’t making predictions about interest rates over a long period.)
Current mortgage rates are some of the highest we’ve seen in 15 years. If you think rates will drop in the next few years, a shorter term will let you take advantage of lower rates sooner.
How to Choose Your Term
Choosing your term is essential to home-buying, but it doesn’t need to be complicated. Here’s a quick guide to help you choose.
Shorter Term (Two or Three Years)
Best For:
- Flexibility
- Those planning to move within five years
- Lower mortgage interest rates
- Smaller breaking penalties
Longer Term (Five Years)
Best For:
- Stability
- Those planning to stay put for five years
- Insulation against changing mortgage rates
