If you have received new mortgage financing or renewed your mortgage over the past few years, you likely benefited from an interest rate that was among the lowest rates offered in recent history. Some may recall the high cost of borrowing in the early 1980s where the average residential mortgage lending rate reached as high as 21.46% in September 1981,1 with subsequent costs of borrowing trending downward over the next 40 years. Fast forward to 2021 when we're seeing some of the lowest rates ever. But despite the low rate you may have received in the past five years, does it make sense to break your existing term and renew at an even lower rate? Let’s explore.
A home is one of the largest expenditures many of us will make, and decisions around debt management can significantly impact long-term wealth. To illustrate a 1% difference in mortgage rates, consider the following scenarios for the same mortgage amount:
|Mortgage A||Mortgage B|
|Rate: 3.5%||Rate: 2.5%|
|Mortgage amount: $300,000||Mortgage amount: $300,000|
|Term: 5 years||Term: 5 years|
|Amortization: 25 years||Amortization: 25 years|
|Monthly Payment: $1,497.81||Monthly Payment: $1,343.90|
The difference of $154 in monthly payments may not seem like much, but it could be additional cash flow made available for savings or other goals. Assuming the above mortgage rates remain constant over the entire amortization period (the life of the mortgage), the total cost of borrowing for Mortgage A is $149,343, with the total cost of borrowing for Mortgage B equal to $103,170. That’s a difference of more than $46,000, not to mention that these savings could be allocated towards long-term investment, which could potentially yield even greater results. Assuming a 5% rate of return, investing the difference could result in accumulated savings of over $92,000 (before tax if in a non-registered account) during the same period.
With mortgage rates at or near historic lows, mortgage borrowers currently locked into a fixed-term rate face a decision. Some lenders will allow you to renew your mortgage term early, or pay it out if you’re going to a different lender, but this option will likely come with penalties and costs. Is the trade off for a lower rate worth it?
It’s tempting to lock in the lowest available rate. After all, nobody can predict when rates will go up, or by how much. What if rates rise by the time you renew your term, and the cost of borrowing at that time is even higher than your current rate? There are many unknowns in the equation, which make the decision difficult. Before rushing to your lender to request an early renewal, there are a number of items you’ll want to confirm first to determine if a lower rate today is a good choice for you. Below are some points to consider before making your decision.
Should you renew early?
The first question to ask is will renewing your mortgage early save you money? In order to answer that question, you will need to determine both the savings and costs of doing so. In the example below, we’ll review the interest cost differences but it’s also important to be aware of the other costs associated with renewing early. Each of these must also be taken into account when assessing the cost or benefit of breaking your existing term and renewing at a lower rate.
If you have a closed2 mortgage term, your lender might charge a fee if you: pay in excess of what’s allowed under the terms of your mortgage; break your mortgage contract; transfer your mortgage to another lender before the end of the term; and/or, pay the entire mortgage in full before the end of term. The penalty will depend on factors such as the amount you are paying, the time remaining on your current mortgage term, and interest rates.
Typically, the prepayment penalty will be calculated as the greater of either three months of interest on what you still owe, or the interest rate differential (IRD). If the interest rate on your mortgage is higher than the current interest rate, and you signed your current mortgage contract less than five years ago, it’s likely the IRD calculation will apply. Some lenders might also charge fees or “breakage costs” in addition to prepayment penalties.
Some mortgage lenders will offer incentives to entice borrowers. A cash-back incentive is one where the borrower receives “cash back” after the mortgage is funded based on a pre-stated amount or formula. In many cases, this added perk could be beneficial to a borrower, providing thousands of dollars that could help assist in cash flow expenses associated with a home purchase such as moving, legal and other costs.
As with all major financial decisions, it’s important to consider your overall financial needs along with your intended goals. Cash-back incentives can be a great option in the right circumstance. Although, if you break the mortgage contract earlier than the term specified, you could be required to repay a portion, or all, of any incentives received.
Tip: Your mortgage document should indicate exactly how your lender will calculate your prepayment penalty. You can also check with your lender for an interim estimate of the penalty. Most lenders should be able to provide information such as prepayment privileges, penalties, how they calculate your prepayment penalty, and what factors they use to determine the penalty.
Sundry fees may also be applicable such as mortgage discharge fees to remove a charge on your current mortgage, and fees to register a new one. These could be significant, and it is important to determine all relevant costs in order to properly assess what your overall savings could be, if any.
Calculating savings and costs
With your penalty costs confirmed, you can compare these with the savings from staying in your current mortgage, and the savings from breaking the mortgage to enter a new term with a lower rate. Let’s review a sample analysis in the following case study.
Case study: Kelsey and Pat
Kelsey and Pat are two years into their five-year mortgage term. Their monthly payments are $1,497.81 based on an original principal balance of $300,000, which was borrowed two years ago at a rate of 3.50%, and amortized over 25 years.
Having always paid on time, and not making any additional payments over the past two years (24 monthly payments), the balance owing today is $284,387. They are currently considering breaking the existing mortgage contract in order to secure new mortgage financing with their lender at a rate of 2.50% for a five-year term.
If Kelsey and Pat were to keep their existing mortgage, their interest costs on the remaining three years would be $28,374. Naturally there would be no additional penalties if they were to maintain the status quo by simply fulfilling the existing terms of their mortgage. Should they decide to renew early, they must include the penalty costs when comparing the cost savings of the new mortgage.
Prepayment penalty calculation
Assuming no other fee considerations, the approximate fees Kelsey and Pat could face would be the greater of either three months’ interest on what is still owed, or the interest rate differential between what the lender would receive on the existing mortgage for the remainder of the term, and what the lender would receive by replacing it with a similar mortgage at a current lower rate.
Reviewing the mortgage schedule with their lender, they confirm that their penalty is $8,500. The prepayment penalty is typically the higher of the three months’ interest or the interest rate differential. For Kelsey and Pat’s analysis, we will assume this is the prepayment penalty. However, it is recommended you confirm whether the IRD applies in your situation. Identifying the IRD cost is a complex calculation, and the amount can change daily. It is always best to confirm your specific costs directly with your mortgage lender.
New mortgage options
Negotiating a new mortgage with a lower rate has also presented additional options. Kesley and Pat are able to consider:
- Option 1) Maintain their remaining amortization of 23 years and make a lower payment
- Option 2) Maintain their existing payment amount and pay off the mortgage sooner
All things equal, a lower mortgage rate will result in either a lower required payment amount if the remaining life of the mortgage remains the same—23 years in our example. Alternatively, if Kelsey and Pat were comfortable with their existing payment amount, then this could serve to pay off the mortgage even faster. The lender may also offer other options not included in this example.
The comparison should be limited to the remaining term on their existing mortgage. Kelsey and Pat have only three years left on their current term. After that, it’s a level playing field once again because they are able to re-negotiate new mortgage terms at that time, with any lender, without breaking a contract. Accordingly, it is these next three years that become the basis for analysis. Note, however, that does not consider beliefs and expectations about whether or not interest rates will be higher or lower in three years, a difficult scenario to predict.
By focusing on the remaining three-year term, we can compare the costs of the existing mortgage with those of the alternatives for the same period. The results below indicate similar interest savings over the short three-year term, but there are several other factors to consider as outlined.
Tip: A financial planner and/or mortgage advisor should be able to help you determine these calculations. There are also a number of online tools available that can help you assess various mortgage scenarios.
Here we can see that, when considering the penalty to break their existing term, the net financial results reveal there would be no benefit to incurring a penalty in order to negotiate a new mortgage. In addition, interest savings are not immediate when the time value of money is considered. That is, the interest savings occur over a period of three years, whereas the penalty cost is an amount to be paid today.
In a situation where Kelsey and Pat are facing cash flow difficulties, it might still be beneficial to incur a slight cost in order to manage their monthly budget. However, they would need to identify how they would pay for the penalty, either by using existing savings, or by including the penalty as part of the new mortgage financing. If the latter, then costs would be even greater as they would then be financing an additional $8,500.
Financial management is a formal part of the financial planning framework. Your financial plan should address your personal goals, needs and priorities. See our article on financial planning and your mortgage. Good planning should also consider other relevant financial planning areas, and the relationships between them.
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Bank of Canada. Average Residential Mortgage Lending Rate - 5 year. Retrieved from: https://www.bankofcanada.ca/wp-content/uploads/2010/09/selected_historical_v122497.pdf
If you have an “open” mortgage, you can make a prepayment or lump-sum payment without paying a penalty.
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