3-year versus 5-year mortgage: How to choose your term

Author: Ciara Rickard

Source: MoneySense

Choosing between a three-year and five-year mortgage can feel like a big decision. While there are pros and cons to both, recent economic turbulence means the stakes are a little higher—and interest rates a lot higher. But things are settling down now. Inflation has finally cooled and the Bank of Canada (BoC) made its first rate cut in four years on June 5. That means we can all breathe a sigh of relief.

But don’t get too relaxed—even though they’re going in the right direction, lending rates are still considered high. So if you’re renewing your mortgage or buying a property, make sure you’ve considered all the relevant factors before signing on. Here we go over the differences between a three-year mortgage and a five-year term to help you get a clearer sense of what might be your best option. 

What’s the difference between a 3-year and a 5-year mortgage?

A five-year fixed-rate mortgage has long been the standard in Canada. If you can score a good interest rate—which was entirely doable up until early 2022—you’ll get to enjoy the peace of mind that comes with a guaranteed low rate for a whole five years. Three-year fixed mortgage rates are typically slightly lower—that’s because the five-year term locks you in for a longer period. Mortgage lenders usually want to take advantage of rising interest rates when they happen, so they make the shorter term a little more attractive. Historically, three-year fixed-rate mortgages haven’t been as popular since they’re just a bit more of a gamble when rates are low—a longer period of stable payments is appealing to most homeowners.

There’s been a bit of a shift recently, though. Interest-rate hikes over the past two years have prompted a spike in the number of homeowners opting for three-year terms. With the current eye-watering interest rates and recent market volatility, a shorter-term commitment has made more sense, as the opportunity to score a better deal will arrive sooner. And no one wants to be locked into higher payments any longer than they have to be. Lenders, however, do want customers locked into higher rates for as long as possible, so a five-year fixed term currently has a slightly lower rate. 

What is a 3-year mortgage?

With a three-year fixed mortgage, the interest rate you agree to at the outset stays the same for those 36 months. This means that variations in the prime lending rate will have no impact on your payments; they will remain the same for that whole period. That predictability is a huge plus when it comes to managing a household budget. 

Historically, three-year fixed-mortgage rates have been a little lower than five-year fixed rates, so opting for the shorter term can add up to a decent saving. Another upside is that if rates drop, the opportunity to take advantage of those lower rates will come sooner than if you’d opted for a five-year term. Shorter mortgage terms typically also have lower penalties if for some reason you need to break your mortgage early.

One of the drawbacks of the shorter-term fixed mortgage is that if interest rates creep up—or, as has happened recently, positively skyrocket—by the end of those three years, you’re going to be stuck with a higher rate when you renew. Speaking of which, another downside is renewing more frequently. At best, it’s a tedious, time-consuming task; at worst, it’s tedious, time-consuming and costly. 

A three-year variable-rate mortgage means your payments are subject to changes in the prime lending rate. So if that rate goes down, so will your payments (that’s good news); conversely, if they go up, so will your payments (not-so-good news).

Whether or not a variable-rate mortgage is a good option for you depends largely on market fluctuations. Rates for this type of mortgage are typically lower than those of fixed-rate mortgages, which is a win as long as the prime rate doesn’t go up too much. And historically, they’ve tended to average out to lower payments over time. But the past few years have reminded Canadians that huge increases are possible, and homeowners who signed on for a variable-rate mortgage pre-2022 have been waving goodbye to an extra several hundreds or thousands dollars every month for the past year and a half. For some, though, these increases are unmanageable and can lead to a potentially dire financial situation.

Fixed interest rate

Pros  

• Payments don’t change with interest-rate fluctuations
• If interest rates fall during your 3-year term, you can take advantage of them sooner
• If you need to break your mortgage early, the penalties are a little lower with a shorter-term contract 

Cons

• More frequent renewals compared to 5-year term
• You’re exposed to market fluctuations more often, so there’s a greater risk of getting stuck with a higher rate 

Variable interest rate 

Pros

• If interest rates drop, so do your payments
• Historically, variable-rate mortgages have averaged out to more savings over time
• The shorter term means you can reassess and adjust your mortgage terms sooner if need be 

Cons

• If interest rates increase, so do your payments
• More frequent renewals compared to 5-year term 

What is a 5-year mortgage?

A five-year fixed mortgage allows you to lock into a specified interest rate for a full five years. Just like with a three-year term, you don’t have to worry about changing markets affecting your payments for the duration of the contract. This is very appealing to homeowners with less tolerance for risk—it’s a nice, long period of predictability. It also means much longer stretches between dealing with the headache of renegotiating. 

Being locked in for longer, however, puts you in a less flexible situation. If interest rates drop, you won’t be able to take advantage of those lower rates—unless you decide to break your mortgage early, a decision that comes with hefty penalty. Or if your financial situation changes or you want to sell your property sooner than anticipated, that five-year commitment is a bit of a roadblock. 

With a five-year variable mortgage, your payments will change according to the whims of the market. Usually, variable mortgage rates are lower, but since currently they will likely give home owners greater savings over their mortgage term, they’re higher than fixed-rate mortgages.  

Fixed interest rate

Pros

• Payments don’t change with interest-rate fluctuations
• Less frequent renewals compared to 3-year term
• If interest rates increase, you’re safe from that for longer 

Cons

• If interest rates drop, you may be locked in and unable to take advantage of them
• There’s less flexibility, which could be difficult in the face of life and/or financial changes
• If you need to break your mortgage early, the penalties are a little higher with a longer-term contract 

Variable interest rate 

Pros

• If interest rates drop, so do your payments
• Historically, variable-rate mortgages have averaged out to lower rates over time
• Less frequent renewals compared to 3-year term 
  

Cons

• If interest rates increase, so do your payments
• There’s less flexibility with the longer commitment 

Deciding on a mortgage term

So, what does this mean when it comes to choosing a mortgage? If the predictions are accurate, a variable-rate mortgage is a great way to take advantage of the downward trend and save some money. Just be sure there’s enough room in your budget to cover higher payments should there be any rate hikes. Five-year variable mortgages are currently being offered at lower rates than three-year variable loans, which could make them the winning choice. 

However, if any level of risk is the kind of thing that keeps you up at night, a three-year fixed-rate mortgage could be a better option—there’s no unpredictability when it comes to that monthly payment, and interest rates will most likely have decreased quite a bit by the time you have to renew. A five-year fixed may not be the best choice right now, as you’ll get locked into higher payments at a time when interest rates are going down. 

Rate decreases aside, the decision largely comes down to your future plans—are you holding on to your property for the long term or do you want to keep your options open?—and your appetite for risk. Find your comfort zone and a plan that works for you.

This article was written by Ciara Rickard from MoneySense and was legally licensed through the DiveMarketplace by Industry Dive. Please direct all licensing questions to legal@industrydive.com.