The Hidden Costs of Popular Mortgages
For most people, shopping for a mortgage entails reading a few articles, scanning the Internet for good deals, and then putting one's faith in a banker or broker. That's often enough to get the job done, assuming you're working with a good mortgage professional.
If, on the other hand, you're more of a doityourselfer, or you're not sure how competent your advisor actually is, then knowing a few key numbers can come in handy.
At a minimum, do your best to:

Understand how interest rates have performed in the past

Know how rates are expected to perform in the future

Understand how rate hikes affect the total interest you pay

Realize that rates are generally random (And therefore, planning for potential interest rate scenarios works better than predicting interest rates)
Knowing the above helps you do two things:

assess your ability to cope with different mortgage rate increases; and

pick the mortgage term with the highest probability of saving the most money.
To illustrate how the numbers come into play, we'll look at four popular mortgage terms:
1the venerable fiveyear fixed
2the conservative 10year fixed
3the open mortgage
4the fullfeatured mortgage with big prepayment privileges.
We'll examine why people pick these terms and how statistics impact each term's total cost of ownership.
1The FiveYear Fixed Mortgage
Why People Choose It: 65% of Canadians choose fixed rate mortgages. Most do it because they fear big increases in variable payments. Others choose fixed rates because salespeople push them, or because they don't understand the alternatives.
The Numbers:

The most prominent research suggests that variable rates save more interest than fiveyear fixed rates 77% to 90% of the time.

Variable rates have averaged over one percentage point less than fiveyear fixed rates for the last 10 years.

Discounted variables are currently over 2.5 percentage points below fiveyear fixed rates. That's the biggest fixedvariable spread in over 30 years!

Looking at past rate cycles back to 1991, prime rate has risen an average of 3.16% from trough to its peak. (1991 is a good reference point because that's when the Bank of Canada started inflation targeting. In turn, 1991 was the start of a major drop in longterm interest rates.)

Prime rate has averaged 4.81% in the last 10 years, and 5.85% since 1991. Prime rate would have to increase 2.56%3.60% in order to return to its longterm average. As of writing, prime rate currently stands at 2.25%.

The big banks predict a 2.92 percentage point increase in prime rate by yearend 2011.

As you can see above, 3% (give or take) seems to be a reoccurring number when it comes to rate hike estimates.
Suppose for a moment that prime rate did, in fact, jump three percentage points in the next 24 months (0.25 per Bank of Canada meeting). And suppose that it remained that high for three more years. In that scenario, taking a variable rate of prime  .50% today would still cost you less over five years than choosing a fiveyear fixed mortgage.
Of course, if inflation exceeds expectations, the Bank of Canada could raise rates more than 3%. The most extreme rate forecasts we've seen is a four percentage point increase (i.e. a 6.25% prime rate). A four point hike would cause variable payments to leap up 50%. In other words, for every $100,000 of mortgage, payments would jump about $214 a month.
Best Bet: History and economist projections are far from infallible, but mortgages are an odds game. The odds suggest variables are still a solid play for the right type of borrower. If you have steady income, reasonable debts, over 10% home equity, liquid savings to cover 36 months of living expenses, and you can handle a potential 50% payment increase, then a variable rate is a good bet. For most wellqualified borrowers, it pays to at least consider a hybrid mortgage (part fixed and part variable).
2The 10year Fixed Mortgage
Why People Choose It: 22% of Canadians choose terms over five years, according to the Canadian Association of Accredited Mortgage Professionals (CAAMP). People generally take 10year terms when they fear abnormal increases in longterm interest rates.
The Numbers:

10year terms cost about one percentage point more than fiveyear terms, as of this writing.

Our own inhouse research has found 10year terms to be cheaper in only one out of 10 rolling 10year periods, dating back to 1967 (the earliest that fiveyear data is readily available).

For a 10year term to be cheaper, fiveyear fixed rates would have to be over three percentage points higher at renewal in five years (assuming equal monthly payments for the first five years). Keep one thing in mind. If, for example, rates soar in year four or six, that means nothing. When comparing a fiveyear to a 10year, all that matters is what the rate is when you come up for renewal in five years.

For fiveyear fixed rates to rise three percentage points, fiveyear bond yields (which guide fixed pricing) would likely have to rise three percentage points as well. That kind of jump far exceeds any major economist forecast.

Since 1991, five year posted rates have never risen more than 1.35 percentage points at renewal.
Best bet: Go with the odds and stick with fiveyear terms or less, except if: 1) You cannot afford payments at rates above today's 10year terms; or, 2) Your tea leaves are calling for a dramatic and unforecasted explosion in longterm interest rates (just be sure you have reliable tea leaves).
3The Open Mortgage
Why People Choose It: A relatively small number of Canadians choose open mortgages. The number would be greater if it weren't for open mortgage rates being so darned high. People usually take open terms when they expect to renegotiate or pay off more than 2025% of their principal within a year.
The Numbers:

Open variable rates are currently one percentage point higher than closed variables. (Open fixed mortgages are too expensive so we'll ignore them.)

Based on current rates, open variables become more costly than closed variables after a nine month holding period. In other words, staying in an open variable more than nine months would cost more than if you took a closed variable and paid the standard threemonth interest penalty to ?break? it early.
Best Bet: People love that open mortgages have no penalties, but this privilege comes at a price. Unless you plan to break your mortgage within nine months, take a closed variable instead of an open.
4A Mortgage with Big PrePayment Privileges
Why People Choose It: People relish the thought of prepaying their mortgage in large chucks without penalty. Even if they don't need them, people often ask for the biggest prepayment privileges possible.
The Numbers:

Only 13% of Canadians make lumpsum prepayments according to CAAMP.

Those who made lumpsum prepayments in the last 12 months prepaid just 1% of their mortgage principal on average. (In dollar terms, that's $1,380 of lump sum prepayments based on the average mortgage balance.)

You can often save at least 2/10ths of a percent by choosing a ?nofrills? mortgage. The best nofrills mortgages have just 5% prepayment privileges (instead of the 1020% found in most fullfeatured mortgages).

A 2/10% interest savings on a $200,000 mortgage can save you over $1,900 in 60 months. Plus, you can still make lumpsum prepayments of $10,000 (5%) per year.
Best bet: Unless you plan to break your mortgage early or prepay more than five percent a year (e.g. $10,000 on a $200,000 mortgage), a nofrills mortgage can be a money saver. Just make sure you understand all the limitations of a nofrills mortgage (many are fully closed for five years or have higher penalties).
The old saying goes: ?The best rate will save you hundreds, but the wrong term can cost you thousands.? With rates near zero and about to rise, proper term selection has never been more important.
Note: The above scenarios and results are approximate and based on various assumptions. All calculations assume a 25year amortization and deeply discounted interest rates. Variable rate scenarios assume the Bank of Canada will increase rates roughly 3.00% by yearend 2011 (as roughly predicted by the Big 5 Canadian banks). The borrower is assumed to make the same payments for each term being compared, with the payments based on the higher rate mortgage. All results are hypothetical. Actual results may be more or less favourable then indicated here. As always, get professional advice specific to your personal circumstances before making any mortgage decision.