Is a short-term fixed-rate mortgage right for you?

This post was first published on October 31, 2022, and was updated on March 26, 2024.

Key takeaways:

• A shorter-term fixed mortgage offers borrowers greater flexibility when rates are poised to fall.
• Mortgage rates are anticipated to start declining in the second half of 2024.
• Borrowers’ risk appetite is the best indicator of the type of mortgage they should choose.
  
  

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After two years of steadily rising mortgage rates, it appears stability is on the horizon for borrowers.The historic 10-part hiking cycle from the central bank – which brought the the Prime rate in Canada to 7.2% and variable rates to around 6% – now appears to be in the rearview, as inflation trends in the right direction.

Markets and analysts are now anticipating mortgage rates will start to decline in the second half of 2024; variable due to interest rate cuts from the Bank of Canada, and fixed as a result of a favourable reaction in the bond market. 

While that’s promising news in general for borrowers, it does pose a conundrum for those looking to get a mortgage now, whether for a new home purchase, or those coming up for a renewal. It’s only natural that borrowers want to take advantage of the anticipated lower rate environment. But what if you need to make a decision now?

There are two main tactics these borrowers can take. One is to take out a five-year variable mortgage rate with the expectation that it will lower materially once the Bank of Canada cuts its Overnight Lending Rate. The other is to take out a shorter-term three- or two-year fixed mortgage rate. This provides some shelter from short-term volatility in the mortgage market, but also offers the flexibility to take advantage of the lower interest rate environment that may occur in the near future.

This strategy is an interesting idea in theory – but is it the best way to go in practice? Let’s explore whether a short-term fixed-rate mortgage could be right for you.

Also read: Canadian February CPI falls to 2.8%

What is a short-term fixed-rate mortgage?

While most Canadians sign up for a mortgage that needs to be renewed after five years, shorter terms are available. You can get a fixed-rate mortgage with a term of as little as one year.

Historically, lenders have offered lower rates for shorter mortgage terms because they have more certainty about how much it will cost them to lend you money. The spread between the best 5-year fixed rate and the best 1-year fixed rate has historically been 40 basis points (bps), or 0.40%.

That’s not true at this moment in time, however. Because of recent trends, short-term fixed mortgage rates are currently higher than their 5-year counterparts - as of March 2024, the lowest 3-year term sits at 4.99%, while the lowest 2-year fixed mortgage rate is 5.59%.

However, the lowest five-year fixed rate is currently 4.79%, and that mere 20-basis-point gap between it and the three-year is pretty appealing to borrowers; demand is booming for three-year terms as a result.

Why would I want a short-term fixed-rate mortgage?

With much uncertainty about what’s to come for the economy, you may want to buy some time before committing to a longer-term mortgage. A short-term mortgage could keep your rate and payment the same for a year or two, at which time you might have better information with which to make a decision.

If you believe that rates will come back down, you might not want to lock into a longer term. A short-term mortgage would afford you the opportunity to take advantage of lower interest rates when it’s time to renew.

Will I save money with a short-term fixed-rate mortgage?

The answer to this question depends on whether interest rates are likely to fall dramatically over the next year. If they do, you could potentially save money by taking a short-term fixed-rate mortgage now and committing to a better rate at the end of your term.

To estimate whether you’ll save money over the course of five years, compare the total cost of a 5-year fixed-rate mortgage with the total cost of a short-term fixed-rate mortgage, plus the estimated cost over the following years. Let’s assume you want to take out a two-year mortgage, followed by a three-year term.

Let’s look at an example using Ratehub’s mortgage payment calculator. A $500,000 mortgage with a 5% down payment amortized over 25 years with today’s best 5-year fixed rate of 4.79% will require a monthly payment of $2,814 and cost $110,632 in interest over the 5-year term.

The same mortgage with today’s best 2-year fixed rate of 5.59% would require a monthly payment of $3,041 and cost $55,513  in interest over the 2-year term. With a 3-year fixed term at a rate of 4.99%, you’d have a monthly payment of $2,870, and pay $70,919 in interest.

With a higher interest rate, both a 2-year and 3-year fixed-rate mortgage will require higher monthly payments than a 5-year term.

Assuming your primary goal is to reduce your monthly payment, you’ll need to make up for this difference over the three years following your initial 2-year short-term mortgage. To get even a slightly lower average payment over five years, you would need to get a 3-year mortgage rate of 4.2% or better when your short-term mortgage is up for renewal:

• Total payments with a 5-year fixed at 4.79% = $14,070
  
• Total payments with a 2-year fixed at 5.59% = $6,082
• Total payments with a 3-year fixed rate at 4.2% = $7,956

2-year + 3-year total payments: $6,082 + $7,956 = $14,038

Are mortgage rates likely to fall over the next year?

While it’s likely that mortgage rates will fall over the next 12-month period, it’s still uncertain by how much.

According to Ratehub’s chart of historical mortgage rates, it would be an anomaly for rates to fall more than 1% over a 12-month period. While rapid swings were more common during the market volatility of the 1980s and 90s, a drop of that size hasn’t happened since the Great Recession of 2008-09.

Analysts are anticipating the Bank of Canada could cut rates twice at 0.25% each by the end of 2024; doing so would bring the lowest 5-year variable mortgage rate to 5.45%, which is still quite elevated when compared to the previous few years.

While fixed mortgage rates have decreased somewhat since the start of the year due to fluctuations in the bond market, this has been by no means a smooth downward trajectory; bond yields continue to be volatile, reacting sharply to new economic data. The possibility fixed mortgage rates could rise higher this year remains very real.

What does all this mean for what mortgage term I should choose?

It’s also worth noting that it’s much more affordable to break a fixed mortgage when rates are rising. That’s because the formula used to calculate your penalty (the interest rate differential, or IRD) describes how much money the lender theoretically stands to lose. In times of rising rates, your lender is less likely to lose money if you break your mortgage, so the penalty for doing so is therefore much lower.

What can I do to save money on my mortgage?

Without a crystal ball to see the future, it’s impossible to know how mortgage rates will change. Instead of trying to game the system, if your appetite for risk is low, choose a mortgage that will give you a predictable payment and protect you from economic volatility.

If rising rates are making it difficult to afford your mortgage payments, your lender or mortgage broker may be able to help. They’ll be able to give you a better sense of your options and how you might be able to lower your monthly payments – or at least stop them from rising.

The bottom line

If you are risk-averse and worried about today's rising rate environment, choose a 5-year fixed-rate mortgage that will keep your payment predictable for the longest reasonable timeframe for the best results. Be sure to compare mortgage rates online and work with a mortgage broker to find the best mortgage rate to lock in.

Also read: 

• Renewing your mortgage in 2024? Here’s what to expect
• Should you pay off your mortgage with a lump sum, or invest?
• Should you pay off your mortgage at renewal?
• Should You Switch From a Variable-Rate to a Fixed-Rate Mortgage?
• The Trigger Rate: Everything You Need to Know
• The 2023 First Home Savings Account: What you need to know
• Mortgages and Inflation: How Do They Affect Each Other?
• How Does the Rising Stress Test Impact Mortgage Affordability?