Lower rate = Lower payment and a Lower balance in 5 years!

 We all know that a lower interest means a lower monthly payment.   But did you know that a lower interest rate means you will also owe less when your mortgage comes up for renewal?    This has been overlooked by consumers and experts alike.  I haven’t seen any articles covering this.  And it should change how you choose your next mortgage product.

It all has to do with the effects of compounding interest.   Let’s take a look at 2 borrowers, each with a $400k mortgage.  Borrower 1 is Mary.   Borrower 2 is Dave.   Mary has today’s 5 yr fixed rate of 3.29%.   Dave has the more normal rate of 5.50% (the rate most experts think we will see in the next 3 to 5 yrs).    We’ll amortize both mortgage over a 25 yr term.

Dave’s mortgage has monthly payments of $2441 and a balance owing of $356,749 at the end of 5 years.   Mary’s mortgage has monthly payments of $1953 and a balance owing of $343,728 at the end of the first 5 years.  Notice the difference in the balance owing after 5 years.    We are talking about a $13,021 difference.  That’s the effects of compounding interest.

In the past, it was normal to expect to pay very little towards your principal balance in the beginning.   That’s because interest rates were much higher…  The average fixed rate over the past 25 yrs is around 7.00%.  If we use 7.00% for this example, the balance after 5 yrs would be $364,178 and monthly payments would be $2801.    The balance owing is $20,450 lower in just 5 yrs.  And you would have also paid $50,880 less in payments over that first 5 years.

We haven’t explored Variable rate with this math only due to the interest rate fluctuations but the savings would be even greater.   That’s because Variable rate has consistently been lower than Fixed rates…   stats show they are lower in over 88% of the time.

I know that rates of 7.00% are not realistic today.  But why are we not talking about consumers paying off their mortgages faster.   We are paying them faster.  We are paying them faster because rates are lower.  Yet, we just keep hearing about a debt crisis.    hmm.. something to think about…

This is why so many people choose Variable rate and short-term fixed rate products.     Short term rates are usually much lower than fixed rates… you pay less monthly and you owe less at the end of 5 years.    It’s also why I recommend Variable rate to my clients in over 80% of the time…..  And why there has only been 2 times in the last 10 years where I said Variable rate didn’t make sense…

Right now, the Bank of Canada and most experts agree that interest rates will not go up for the next 1 to 2 years.. maybe longer..

The message is clear:  Focus on the lower rate but DON’T get lulled into those ‘No Frills’  or ‘low rate’ products.   Don’t get lulled into the BIG SIX BANKS fixed rate mortgages that carry the unfair prepayment penalty calculation (my regular readers will know about this… for those don’t here’s a link to read).

Your best interest is my only interest.    Like this article?  Please share with a friend.   I reply to all questions and I welcome your comments.

Steve Garganis 416 224 0114 steve@mortgagenow.ca