Mortgage Dilemma

First-time home buyer Kathleen Kemp figures she's done well negotiating a five year mortgage at 6.65 percent.

She got three-quarters of a percentage point off the posted rate of 7.4 per cent because she had a good-sized down payment, she says.

" This is probably a unique historic event in my life," says Kemp, a university teacher in her mid-30s. "I wouldn't say house prices in Toronto are reasonable. But they're less exorbitant and the lower interest rates have made it much more affordable."

For many first-time buyers, who are seeing the lowest interest rates in their lifetime, the current five-year mortgage rate seems like a heck of a good deal.

And, in fact, most first-time borrowers and a lot of mortgage renewers opt for the security of a fixed five-year term.

But many experts say most buyers would do even better if they took out shorter six month or one year mortgages, which carry lower interest rates.

Although short-term rates tend to be more volatile, studies have shown that over the long haul, short-term borrowers still come out ahead.

Consider the current situation. The difference between long-term and short-term rates is 2 percentage points. A five-year mortgage costs 7.4 percent. A six month mortgage costs 5.4 per cent.

If you took out a six month mortgage today, and renewed it every six months for the next five years, the chances are very slim that you'd pay on average 7.4 per cent over the five-year term, experts say.

In fact, a study conducted for Canada Mortgage and Housing Corp. late last year found borrowers were better off selecting one-year terms 85 per cent of the time over the last 15 years.

Borrowers who opted for five-year terms between 1985 and 1989 paid on average as extra $3,058 in interest on a $100,000 mortgage, the study for the federal agency concluded. Between 1990 and 1994, that figure rose to $9,253, the study said.

"If you look at where our economy is now, you'd be crazy to take a five-year mortgage. I don't care how low they are," said Alan Watkins, a mortgage broker and chartered accountant with Alpha House Mortgage Corp.

"To be taking out a five-year mortgage at this juncture, you have to be betting on the prospect that short term interest rates are going to rise dramatically," said David Rosenberg, senior economist at investment dealer Nesbitt Burns Inc.

"I can't see the six-month rate going over 7 per cent in the next five years, there's no way in the world," says Tom Delaney, president of Financial Group.

Yet, few home buyers - especially first-time buyers-opt for short-term rates.

The Royal Bank of Canada says only one-third of its first-time borrowers are taking out mortgages with terms of one year or less. At the Bank of Montreal, that statistic is even lower with just 20 per cent of first-time customers taking out short-term mortgages.

Most borrowers who lock in for longer terms say they like the security of knowing what their monthly payments will be for the foreseeable future.

"First-time buyers with only 5 per cent down and a big monthly payment relative to their income just can't afford to gamble," says Tom Alton, president of Bank of Montreal Mortgage Corp. "they want to sleep at night."

Even at these low rates, the monthly mortgage payments on her three bedroom home in East York will be considerably higher than the rent she's paying on her bachelor apartment.

"The prospect of watching interest rates go up and down on a roller coaster ride doesn't really appeal to me," she says.

Mortgage renewers have a slightly different pattern, bank officials said.

At the Bank of Montreal, 70 per cent of renewers are taking out mortgages with terms of one year or less. At the Royal Bank, two-thirds of renewers are opting for shorter terms.

"With renewals, people have some play in their budget. They've lived with their mortgage payments for five years. Their salaries may have increased and they may also be thinking of moving soon, so they don't want to be locked in," said the Royal Bank's marketing manager, Christian Findlay.

Whether borrowers opt for short or long terms, she says, "is really a very personal decision."

The two biggest considerations, in her view, are how much room borrowers have in their budget for interest rate fluctuations, and whether they think rates will rise or fall in future.

A third factor is how closely the borrower wants to monitor interest rates. "Are they someone who reads the financial pages every day?" she asks.

Bruce Flanagan, a residential mortgage account manager for the Royal Bank of Canada who signed up Kemp, says most of his clients are going long term.

Short-term rates have jumped sharply on several occassions in recent years, he notes. In September, 1992, the rates spiked two percentage points in a single day. In March, 1994, they jumped two percentage points within two weeks, he says.

"That's what I'm telling people," he said. "It can be a bumpy ride."

But most experts say the prospects for continuing low interest rates are good. "There's still, in my view, some room on the downside on rates," says Delaney.

"My own view is we're in a decade of low interest rates," says Alton. "we'll have unforecastable political events which can put a spike in the rates, but the rates come back down again."

Watkins, the mortgage broker, says he has a solution for borrowers who want the security of fixed monthly payments along with the benefits of lower short-term rates.

Borrow short-term, he says, but make higher monthly payments based on the five-year rate. That way when your mortgage comes due, if short-term rates have risen, it won't throw your budget out of whack. And if short-term remains low, you'll come out ahead because you'll have paid off your mortgage faster.

"Instead of waiting 25 years to hold a mortgage burning party, you get to have yours after 16 years," Watkins says.

The difference in monthly payments on the average $100,000 residential mortgage is about $125, bank officials said. A five-year mortgage at 7.4 per cent costs $725.28 a month. A six-month mortgage at 5.4 per cent costs $604.58.

Mortgage brokers arrange loans for clients with both conventional and non-conventional lenders, who pay the broker's fee. There's no cost to the client, her says.

Kemp says the idea sounds interesting, but she's not ready yet to plunge into what seems like the world of high finance.

"That's nice," she says of Watkins' proposal. "Someday I'll go to a financial adviser. But I'm still a low-fuss person. You don't get any guarantees with short-term rates. I would find it a bit stressful."