If you’ve been watching rates lately, you may be wondering if you could break your mortgage to save a pile of cash too. The prime rate hit rock bottom in 2009 at 2.25% and it’s only risen slightly, to 3.0%, since then, meaning that depending on the discount you get from your lender, you can get a closed variable rate mortgage from 2.2 to 2.25%. The best available current five-year fixed rate is also a steal—it’s at about 3.8%, not far from its all-time low. (All rates were accurate as of March 2011.) Breaking your existing mortgage to switch to a lower rate could save you hundreds of dollars every month—or knock years off the length of your mortgage so you own your home sooner.
But you have to be careful. Your mortgage is probably the most complex contract you’ve ever signed. Make a wrong move and you’ll end up on the hook for penalties of $20,000 or more. The key is to run the numbers and get some advice before you approach your lender. Luckily, a quick analysis to see if you’ll come out ahead is relatively painless and free. Read on, and we’ll show you how to do it.
WHAT’S YOUR ULTIMATE GOAL?
Your first step is to decide what you want to accomplish. Most people are looking to do one of three things: to reduce the total cost of their mortgage, consolidate other debt (such as credit card debt) into their mortgage, or reduce their monthly payments, whatever the cost.
Keep in mind that lowering the cost of your mortgage can be done in two different ways. You can keep the total length of the mortgage—called the amortization period—the same and reduce each monthly payment. Or you can keep your monthly payments the same, and shave years off your amortization period so you’ll own your home outright sooner. Either way, you could save a pile of money.
WHEN IS IT WORTH BREAKING YOUR MORTGAGE?
The rule used to be that it’s worth breaking your mortgage when you can get a new rate that’s at least two percentage points lower than your current one. But that’s all changed. Because the rates are so low now, it’s worth switching for a much smaller drop. For instance, if you had a five-year fixed mortgage at 5.0% you might be eyeing the current rate of about 3.8%. That’s a difference of just over one percentage point, but it could reduce your overall interest costs by around 30% and lower each monthly payment by 15%, depending on your amortization.
Because each percentage point drop represents a bigger proportion of the total rate, the new rule is that if you see a rate that’s just 50 basis points lower than your current rate, it’s worth running the numbers. Depending on the penalty for breaking your existing mortgage, you could see big savings.
ARE YOU ALLOWED TO BREAK YOUR MORTGAGE?
In most cases the answer is yes. When you signed your mortgage document, you agreed to a whole slew of conditions, and one of them was likely a penalty for exiting your payment schedule before the current term is up (most terms are one, three or five years in length).
It doesn’t matter whether you do it by paying the whole mortgage off in cash, or by switching to a new mortgage—if you depart from the repayment schedule you agreed to before the term is up, you’re breaking your mortgage. Your lender will get less in interest payments out of you than you initially agreed to, so there will usually be a penalty. “When people buy a home they’re not thinking of breaking their mortgage,” says Vince Gaetano, principal mortgage broker with MonsterMortgage.ca in Toronto. “But the reality is that almost 40% of mortgage-holders will have to refinance and when they do, they’ll have to deal with their penalty.”
SO WHAT WILL BREAKING MY MORTGAGE COST ME?
There are penalties for breaking both fixed- and variable-rate mortgages, but the penalties for breaking a variable mortgage are usually much lower. “Any time you break a mortgage, the penalty may be too high to make it worth it,” says Kim Gibbons, a mortgage broker with Mortgage Intelligence in Toronto. “But you can usually recapture that penalty pretty quickly if you have a variable-rate mortgage.”
In this case, calculating that penalty is easy. Canada’s National Housing Act mandates that for variable-rate mortgages, the penalty is always equivalent to three months’ interest. For instance, imagine you have a $200,000 variable mortgage at 3.8%, amortized over 25 years. On this particular mortgage, let’s say your monthly payment is $1,030, and the interest rate portion is $627. Multiply that by three and you get $1,881. That’s your penalty.
WHAT’S THE PENALTY FOR BREAKING A FIXED-RATE MORTGAGE?
A fixed-rate mortgage has a much higher penalty. It’s also much more difficult to calculate what the penalty is. In broad strokes, the penalty is based on the interest rate differential, or IRD, which is the difference between the rate of your current mortgage and the rate the lender can now get for his money. It’s tricky to calculate, so you’ll likely need a mortgage broker to do it for you.
To show you just how stiff the penalties can be, Marcus Tzaferis, founder and chief economist of MorCan Direct in Toronto, estimates that a typical penalty for breaking a $200,000 five-year fixed-rate mortgage locked in at 5.9% after two years, given today’s 3% prime rate, would be roughly $12,000.
ARE THERE ANY OTHER COSTS?
Unfortunately, yes. Refinancing, or breaking your mortgage to switch to a new one, isn’t much different from applying for your first mortgage. So you’ll still have to fill in an application and go through a credit check. You may also have to do a title search, and there may be appraisal and inspection fees. The process can be quite lengthy and expensive—it can cost you $1,000 or more.
If you’re planning on selling your house in a few years, it’s probably not worth it. On the other hand, if you plan on staying put for the long run, refinancing can save you a bundle.
HOW MUCH CAN YOU SAVE?
Let’s run a few numbers to find out. We’ll start by looking at what happens when you break an existing variable mortgage to switch to another variable mortgage with better terms.
Imagine that you have the $200,000, 25-year variable mortgage that we described earlier. When you took the mortgage out, the rate you agreed to was prime plus 80 basis points. Right now, the prime rate is 3.0%, so your current rate is 3.8%. In this case, your monthly payment comes to $1,030. Of that, $627 goes towards paying your interest.
The new variable-rate mortgage you’re looking to switch to offers a better rate. Instead of charging prime plus 80 basis points, the new mortgage charges prime minus 70 basis points. Because of the lower rate, switching would save you $14,167 in interest payments over five years. As we mentioned earlier, the penalty for breaking your existing mortgage is equal to three months worth of interest, or $1,881. In addition, you would pay about $1,000 in administrative costs. So after the penalty and the admin costs, you would save $11,286 over five years. Is that worth it? Most people would say that it is.
Now let’s look at what happens when you break a fixed-rate mortgage to switch to a variable-rate mortgage. This situation is more complex, so we asked for Tzaferis’ help again to get us through the calculations.
In this case, let’s say you’re two years into a five-year $200,000 mortgage at 5.9%, and you want to switch to a variable-rate mortgage at prime, or 3.0%. You still have 36 months remaining on your mortgage, so if you kept the mortgage until the end of your five-year term, you would pay a total of $32,532 in interest over the remaining months. On the other hand, if you broke the mortgage and took the prime rate at 3% (and the rate stayed at 3% for the rest of your term) then you would pay $15,815 in interest over the next 36 months. So you would enjoy a savings of $16,717 in interest payments. Sounds pretty good, so far.
However, you still have to pay the penalty and administrative costs. As we mentioned above, a typical penalty for breaking your fixed-rate mortgage would be about $12,000, and you would pay about $1,000 in administrative cost. So your total savings will be about $3,700 ($16,717 minus the penalty of $12,000 and the $1,000 admin cost). In this case, it may be worth it, but only just. To calculate the total potential savings from breaking your fixed-rate mortgage, ask a mortgage broker to run a few scenarios for you. Many will do it for free.
FIXED OR VARIABLE?
In both the scenarios above, the new mortgage was a variable one, but a lot of people could benefit from switching to a new fixed-rate mortgage too. After all, the five-year fixed rate of 3.8% isn’t all that much higher than the 2.25% currently being offered for a closed variable rate.
So which kind should you choose? The decision ultimately comes down to whether you want a lower rate with more uncertainty, or a slightly higher rate that’s more predictable. Historically, the majority of homeowners have opted for variable-rate mortgages which go up and down with prime, and studies have shown that over the past couple of decades, those who went variable have done better. But some brokers say the past is not a good indicator of what the future will bring. That’s because interest rates have been slowly declining for decades, and now that they’ve hit the bottom they’re starting to creep up again. Rates may increase over the next few years, meaning that variable-rate mortgage holders could lose out. If that scenario could keep you up at night, you might prefer a fixed-rate mortgage, where the interest rate stays the same throughout the term of the mortgage.
WHERE CAN YOU FIND THE BEST RATES?
You may be tempted to walk into your local bank and sign on the dotted line for the first mortgage that you qualify for, but it pays to shop around. Long-term customers can get excellent rates from their banks, but you should also try out a mortgage broker. These are professionals trained to represent you, the borrower, in obtaining financing from a variety of lending sources. In most provinces, they are required to be licensed.
Because mortgage brokers are not employed by any one financial institution, they are not as limited in the products they can offer you. They can seek out the best mortgage to suit your specific situation, whether it’s with a bank, trust company, credit union or private funds. “I deal with over 50 lenders,” says Kim Gibbons of Mortgage Intelligence. “I try to get you the best deal and whoever wins your mortgage pays me a finder’s fee. There is no direct fee to the client.”
After you visit a broker, follow it up with a visit to your bank. Show them what the broker is offering you and see if they can do better. Finally, before you start looking around, make sure you actually have a choice. With some mortgages, if you want to renegotiate, it has to be with your existing lender, at least until the original term is up.
CONSOLIDATE YOUR DEBT
Until now, we’ve been assuming that you’re refinancing to lower the cost of your mortgage, but many people refinance to consolidate their debt too. In this situation, you’re looking to roll high-interest-rate debt—such as credit card balances—into your mortgage to simplify your debt payments and lower your interest rate. By doing so, you could reduce your rate from 19%—the typical rate on a credit card—to 3% or lower, and save thousands of dollars in interest payments.
LOOSEN THE NOOSE
The final reason many people refinance isn’t a happy one: It’s because they’re struggling to make their monthly mortgage payments. This is often due to unemployment, illness or some other unforeseen circumstance. In this case, the goal is just to get those monthly payments lower, no matter what the cost. And unfortunately, there often is one: you can end up paying more over the long run as a result.
The typical strategy in this case is to lengthen the amortization period, for instance to break a 25-year mortgage and get a 35-year one. Each payment will be lower, but you’ll be making them for 10 more years, so the total cost of your home will be higher. If you’re lucky, you’ll be able to refinance at a lower rate. That will help to offset the longer amortization period, and you could even come out ahead.
WHAT ARE THE RISKS?
When you refinance, you face the same hazards that can trip up any borrower, whether it’s your first mortgage or your third. Unscrupulous lenders can tack inflated fees onto your new mortgage, some of which they may not disclose up front. They could also introduce new, higher penalties for breaking the new mortgage. “Many financial institutions don’t give you a concrete idea up front of what the penalties for breaking your mortgage actually are,” says Gaetano of MonsterMortgage.ca. “Often what the penalties actually are, and what you think they are, can be two different things.”
To prevent any nasty surprises, after your lawyer has read your mortgage, you, too, should sit down one evening and read it from start to finish. If at any time you don’t understand a particular statement or clause, make sure to get it clarified before signing.
EVEN MORE WAYS TO SAVE
If you get the big stuff right, you’ll be fine. But you can do even better if you get the details right too. For instance, when you’re considering a new mortgage, ask if the interest is compounded monthly or semi-annually. The less frequently the interest is compounded the better—semi-annual compounding could save you hundreds of dollars. Also, ask how often the rate changes. Most variable mortgages have rates that fluctuate monthly. However, there are several that only change every three months. This offers you more protection when rates are rising.
Finally, consider the prepayment options. The last thing on your mind when you take out a mortgage may be whether the bank will let you pay more than the minimum, but this is important. Four years from now, your salary might be higher, and if you’re allowed to pay extra, it goes straight to the principal and can knock years off your mortgage.
Most mortgages allow you to prepay between 10% and 25% of the mortgage principal annually. But Chad Robinson, president of Verico Best Interest Mortgages in Ottawa, says that it’s a growing trend to offer customers a “No Frills” product that severely limits your ability to prepay and can even make it impossible for you to switch from one lender to another entirely until the term of the mortgage is up. “One Canadian bank is offering just such a mortgage,” says Robinson. “The rate appears attractive; however savvy customers can find equal or better rates without the handcuffs.”
Finally, if you have a prepayment option on your mortgage and you plan to refinance, make your annual prepayment—usually between 10% and 25%—before getting the penalty calculated. If you don’t have the money, your mortgage broker will often give you a one-day loan, so your penalty can be reduced. “Very few people use this key option before having their mortgage penalty calculated,” says Tzaferis of MorCan Direct. “But this simple step can save you hundreds of dollars up front.”
Five signs it’s time to renegotiate your mortgage
1. You can get a rate at least half a percentage point lower than your current rate. In the past, the rule was it wasn’t worth breaking your mortgage for a new one unless the new rate was at least two percentage points lower, but with mortgage rates at historical lows, even a small drop of 50 basis points can mean paying hundreds less every month.
2. You want to pay off your house sooner. You can refinance to shorten the length of your mortgage and pay less in interest over the long run. Refinance at a lower rate, and you’ll save even more.
3. You have a lot of credit card debt. If you have enough equity in your home, you can refinance and roll your credit card debt and other loans into your mortgage. That can mean a drop in the interest rate from 19% to 3% and thousands of dollars of savings.
4. You want to convert a variable-rate mortgage into a fixed-rate mortgage. Many economists say interest rates will be heading up soon. If you want to lock in, now’s the time. As of mid-November, the five-year fixed rate was only about 3.8%—not much higher than its lowest point ever.
5. You can’t afford your payments. Lenders don’t like foreclosing on homes, so they’ll often help you refinance instead. Depending on the kind of mortgage you have and the amount of equity you have in your home, you may be able to extend the term of your mortgage loan and reduce your monthly payments.
Excerpted from MoneySense Guide to Buying and Selling Your Home (Rogers Publishing Limited, $9.95). The book is available at bookstores and newsstands or online at http://moneysense.ca/myhouse