5 things to do before locking into a mortgage rate

When mortgage rates are low, it's easy to think they'll only go up – better lock in before they rise! But is that the best strategy? Before signing anything, here's what you should do first.

When rates are low, it’s tempting to lock into what seems like an amazing deal in case there’s a sudden change. The same instinct can come up if you think rates are going to rise. Even if the current mortgage rate isn’t a great deal, it can’t be worse than what you’d get if you wait...right?

So what should be your first step?

Like with all financial decisions, it’s important to not get carried away by any feeling of panic you sense from friends, family or even the media. After all, it’s your money, and you should do a little bit of research before you decide how to spend it.

Market analysis has shown that, in an ideal world, mortgage borrowers can optimize their mortgage term selection.

In theory:

• Mortgage borrowers are better off when they lock into longer-term mortgages at the trough of the interest rate cycle and stay short as interest rates approach the peak of the cycle.

In practice:

• The opposite tends to happen. Mortgage borrowers go long as rates are rising because they worry mortgage rates will continue to rise. And they go short as rates fall, hoping to lock into a long-term rate when rates are at their lowest.

So what should you do? Start by running some numbers. Let’s take a historical example:

• Say you have lenders offering a one year-mortgage term at 6.50 per cent and a five-year mortgage term at 8.50 per cent.
• That one-year rate may look attractive relative to the higher five-year mortgage rate.
• Bi-weekly mortgage payments on a $100,000 mortgage at a discounted rate of 6 per cent on a one-year term would be $319.51.
• In comparison, bi-weekly payments at a five-year term of 8 per cent (assuming a 1/2 basis point discount) would be $380.98.
• The difference between the two options is $61.47 every two weeks.

Based on strict comparison of the size of the bi-weekly payment, the one-year term appears desirable...

Yet, in the above example, the initial market theory would suggest borrowers should consider locking into longer terms – a three-, five-, or even seven- year term mortgage.

Why? Because the mortgage yield curve, or the absolute difference between short- and long-term mortgages, is currently large.

• The gap of 200 basis points is high by the standards of the time. And that large gap is telling us something about financial markets: rather than continuing to fall, interest rates could be pushed higher, particularly at the long end.
• Ultimately, the borrowers who continue to go short waiting for the right opportunity to lock into a longer mortgage rate could be in for some disappointment.

You should also remember that rates you are initially quoted are the lender’s  “posted” rates, or the rate that you see on display – and it can be quite different from the “effective” rate, or the rate you’ll actually be charged.

• In reality, what you’ll pay can be anything between 25 to 75 basis points off the posted rate, depending on the size of your combined accounts and relationship with your lender.
• If your mortgage is up for renewal, there’s always the possibility of checking out what other institutions may have to offer.

In the end, choosing to lock into a long-term mortgage or going for a short-term option will depend on what rates the lenders are offering, how much leeway you have to negotiate within, and which way you think interest rates will go.

• Whatever you decide, take the time to run the numbers and factor in all available information before you jump in. It can make a big difference in your monthly payments.

Smart Tip provided by The Financial Pipeline. Founded in 1996 by a group of portfolio managers, The Financial Pipeline is dedicated to providing financial knowledge and education to anyone and everyone with even a passing interest in finance. Our motto, “Financial Information For the Rest of Us,” speaks for itself.