Joakim Tjernell was pretty proud of himself—he’d done a damn good job of shopping for a mortgage. It was back in June of 2009 and Tjernell, a 32-year old translator, had been eyeing units in a slick modern condo building on Toronto’s Bathurst Street for a while. There was a lot of paperwork—Tjernell’s wife is a freelance graphic designer, so they had to prove that she had regular income. “This was the first time we had a mortgage, so we were nervous about getting approved,” he recalls.
But not only were they approved, their mortgage broker came through with a great offer on a variable-rate mortgage from Scotiabank. The $280,000 loan had a 25-year amortization and a floating rate of just 2.90% to start. Tjernell was sure he’d bagged a deal.
But last May he got an email newsletter from his broker suggesting that he could do even better. Tjernell thought that all variable-rate mortgages were the same, but that wasn’t the case. His original mortgage offered a rate of prime plus 40 basis points (there are 100 basis points in one percentage point). But the newsletter was offering variable-rate mortgages at prime minus 40 basis points. Was a difference of just 0.8 of a percentage point worth switching for?
When his mortgage broker ran the numbers he found out it was. Breaking his old mortgage to switch to the new one could mean a savings of more than $5,000 in interest payments over the life of Tjernell’s mortgage—enough for a couple of nice vacations down south for him and his wife. “As soon as I realized that, I paid the $1,800 penalty, and kept the amortization period the same at 25 years,” he says. “I’m now saving $150 a month on my payments.”
If you’ve been watching rates lately, you may be wondering if you could break your mortgage to save a pile of cash too. Variable rates hit rock bottom just over a year ago at 2.25% and they’ve only risen slightly, to 3.00%, since then. The current five-year fixed rate is also a steal—it’s at 3.39%, close to its all-time low (all rates were accurate as of mid-November). 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 accomplish one of three things: they want to reduce the total cost of their mortgage, they want to consolidate other debt (such as credit card debt) into their mortgage, or they want to reduce their monthly payments, whatever the cost.
You should be clear about what your goal is, because it will have a big impact on how you proceed. We’ll deal with the first situation first—lowering the total long-term cost of your mortgage—then look at the other two situations a bit later. 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 3.39%. That’s a difference of less than two percentage points, but it actually means reducing your rate by more than a quarter, which could translate into reducing each monthly payment by 30%. If you were paying $1,500 a month before, you’d save about $450 each and every month. Most homeowners would agree that’s definitely worth switching for.
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 30 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.”
In other words, the question you should ask yourself isn’t “Am I allowed to break my mortgage?” it’s more like: “How much is breaking the mortgage going to cost me?”
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. You may barely break even—or you could even lose money due to the penalty and administrative costs. 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 3.00%, 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 $3,717 ($16,717 minus the penalty of $12,000 and the $1,000 admin cost). In this case, it would probably 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 3.39% isn’t much higher than the 3.0% 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 that we’re currently turning a corner, and the past is not a good indicator of what the future will bring. That’s because interest rates in Canada have been slowly declining for decades, and now most economists agree that they’ve hit the bottom and they’re starting to creep up again. If rates increase over the next few years as some fear they will, 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. Elizabeth Campbell, a 50-year-old single executive secretary, says she’s held fixed-rate terms on her three-bedroom, semi-detached home in Scarborough, Ont., since she bought it, and has no regrets at all. “It’s too risky for me to take a variable-rate mortgage,” she says (we’ve changed her name to protect her privacy). “My job is pretty secure and I know that I can handle the monthly payments. Whether interest rates go up or down a little over the lifetime of my mortgage, I don’t really pay it much mind. I just feel secure knowing that I can budget around the rate I’m paying now—4.39%.”
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. We’ve heard of long-term customers getting 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.”
Stewart Wong and his wife Erin went to talk with a mortgage broker three years ago. “We didn’t know much,” says Wong, a 35-year-old communications manager at a non-profit organization in Toronto. “She did a good job educating us in terms of what to look for in a good mortgage. We wanted the ability to put lump-sum payments against the principal of the mortgage because we take our tax refund every year and apply it to the mortgage. We needed to be able to do that without a penalty.”
Keep in mind, however, that just like there are good and bad lawyers and teachers, there are good and bad mortgage brokers too. So it’s probably a good idea to visit a broker first, but you might want to follow that 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. Watch for this clause on your new mortgage too. It’s better to go for a slightly higher rate than to be tied to one lender for the entire term.
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%, and save thousands of dollars in interest payments.
That’s what Roxanne Saunders, 51, did this past August. At the time, she had $50,000 in high-interest rate debt on her HBC credit card. Hoping to retire in four years and clean up her finances, Saunders looked at the equity she had in her home—about $255,000 on a $430,000 condo—and renegotiated a $225,000 mortgage at a variable rate of 2.25%. She says it’s given her some much-needed breathing room in her monthly budget, paying $600 a month less in total debt payments than before she refinanced. “I think I’ve put the bank manager’s children through college with the money I’ve spent on interest payments over the years,” says Saunders. “But I plan to retire at 55, sell the condo and invest in a retirement property outside of the city. This plan works well for me.”
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 a number of unnecessary or inflated fees onto the cost of 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.
It’s not going to be the most entertaining evening of your life, but Sandra Martin, a magazine editor in Toronto, did it and she’s glad she did. Before she and her husband Matthew James signed their “very thick” mortgage document, they each sat down and read the whole thing through. To their surprise, they found a mistake that could have cost them thousands of dollars. “We were proactive,” says Martin, 39. “The interest rate we were agreeing to pay for the term of the mortgage had been written down as ‘prime plus 0.484’ instead of ‘prime plus 0.448’. We made sure it was changed before we signed the final papers.”
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.”