STRATEGY SHEET
April 2001
Why Short-Term Convertible
Mortgages are Generally Best
© Talbot Stevens
Everyone with a mortgage has to make decisions that can produce big differences in their total mortgage costs.
The biggest factor in how much your total interest costs are is how quickly you pay back the loan. By choosing weekly or bi-weekly payments, a 25-year mortgage is paid off in 20 years, assuming 8% interest. Paying monthly with a 20-year payback period produces the same savings of over $30,000 in interest on a $100,000 mortgage.
Another decision to make is the length of the mortgage term. This defines how long the contract with your lender is in force before the mortgage is open to be paid off, renewed, or transferred to a new lender offering a better deal.
The mortgage market is very competitive, and offers borrowers an overwhelming number of options to choose from. Closed mortgages are locked in for terms of one to ten years or more. Open mortgages can be repaid at any time, and usually have 6- or 12-month terms. Six-month convertible mortgages give you the flexibility of an open mortgage (see below), but for about 0.5% less than the rates charged on open mortgages.
Historically, the interest rates on shorter terms have averaged almost 1% lower than longer terms of 5 years or more. A 0.75% difference can save $15,000 in interest per $100,000 borrowed over 25 years.
An additional benefit of a convertible mortgage is the flexibility to convert at any time of the year and save even more.
If, for example, you inherit some money or your stock market savvy produces a big windfall, you might want to pay off your mortgage completely. With a 6-month convertible mortgage, your renewal is less than 6 months away, when you could pay the mortgage out. If you didn't want to wait, you could convert to an open mortgage and pay it off immediately without penalty.
The flexibility of a convertible mortgage also allows you to benefit when rates change in either direction.
It is interesting how you can benefit even when rates rise. If you have a good relationship with your lender, as soon as you hear that mortgage rates have gone up, you could call your lender and ask them to convert to a new term today based on yesterday's lower rate.
If mortgage rates drop, even by 0.25%, with a 5-minute phone call you could instruct your lender to "convert" to a new convertible mortgage with the lower rate. There is no limit to the number of times you can do this. Here, the flexibility allows you to immediately benefit from the lower rates instead of months or years later. This is obviously more important when the economy is slowing and interest rates are expected to fall.
If you don't need the security of locking in your payments, the often-lower rate and flexibility of a convertible mortgage can make it the best choice for borrowers.