Should You Break Your Mortgage For a Lower Rate?

This is a guest post by regular reader, and personal finance enthusiast, Sampson.  After discussing my mortgage situation, I had many questions from readers about their own.  Sampson tries to answer the most common question, should you break your mortgage for a lower rate?

The recent nosedive in fixed rate mortgages has gotten many, including myself, to reassess their current mortgage contracts. Whether you have one of those wonderful Prime-minus variable rates, or locked in a fixed rate a few years ago, the current record low fixed rates have many asking themselves whether breaking their existing contracts would be advantageous.

There’s no simple answer, you first have to know why you would like to break your existing contract.

  • Do you want to pay off your mortgage faster?
  • Do you want better monthly cash flow?
  • Are you worried about the potential of future inflation?

Factors to consider

1. Penalty for breaking existing mortgage

  • call your current lender to get this figure
  • can you pay it with cash, or will you roll it into the new mortgage?

2. Fees associated with transferring mortgage, land titles, and other legal fees

  • make sure to negotiate with the new lender, they will often cover these expenses

3. Flexibility of the new mortgage

  • what are the maximum prepayment amounts
  • what are the penalties if you break the new mortgage

4. Penalties

  • Most penalties are now calculated using an interest rate differential (IRD) calculation. This method of calculating the penalty was designed so that banks could recuperate nearly all the lost interest they would have earned if you stayed with their institution at your current interest rate.

So in most cases if you go to a lower rate you typically MUST maintain your old monthly payment to have a lower remaining principal balance at the end of the term.

What Numbers Should be Compared?

  • Principal balance – important if paying your mortgage off sooner is critical
  • Minimum payment – important if job security, or future income is in question
  • Cash flow differential – important for rental properties

Alternatives to Pay Down The Mortgage Sooner

  1. Biweekly payments – you do this right? If not start today.
  2. Maximize prepayment options
  3. Increase biweekly payments (anywhere from 0-20%)
  4. Make annual lump sum payments

An Example

Here is an example of the potential savings (without considering the penalty)

Assumptions:

  • Current rate = 5.5%
  • 1.35 years into the mortgage
  • Biweekly payments maintained at current amounts
  • One annual lump sum payment in the amount of 1 months payment

Interest rate differential: (Old rate)-(New rate)
Initial Mortgage 0.5% 1.0% 1.5% 2.0% 2.5%
$100,000 $1,796 $3,563 $5,301 $7,010 $8,690
$200,000 $3,593 $7,126 $10,602 $14,019 $17,380
$300,000 $5,389 $10,690 $15,903 $21,029 $26,070
$400,000 $7,186 $14,253 $21,203 $28,039 $34,761
$500,000 $8,982 $17,816 $26,504 $35,048 $43,451
> $500,000 Hire a financial planner!  ;-)

The Mortgage Calculator

I’ve been using a mortgage comparison calculator my wife made in excel. Hopefully you’ll be able to use it to help you compare different scenarios.

If you determine that paying the penalty for breaking your exiting contract make sure you have the discipline to stick to your new plan. If you determine that you need to maximize your top up amounts to benefit, make sure you stick with it otherwise you may be better off in your old contract and using your prepayment options.

Good luck and happy mortgage hunting!

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Ed Rempel
11 years ago

Hi Corinne,

5% is a relatively high mortgage rate. Rates have been lower than that for nearly all of the last decade. However, you would have to calculate whether or not it is worth it to pay the penalty.

We are recommending 1-year mortgages today and are getting 2.35%. You can get a lower rate with a variable, but we are recommending to take a 1-year fixed and wait until we can get bigger discounts on a variable. Variable mortgages were at prime -.85% for years before this crisis, and are only about prime -.5 now.

If there will be a $10,000 penalty, then you have a closed mortgage, not an open mortgage. 40 years is your amortization (how long it will take to pay off with your current payment), not the term of your mortgage.

Your bank will also charge a discharge fee to transfer out the mortgage ($25-300), plus the new bank might charge legal and appraisal fees. Sometimes they cover these.

We would recommend not to take a cash incentive. They are called “cash back”. You usually only get them if you sign up for a long term closed fixed-rate mortgage at a high rate. If you negotiate the lowest possible rate, there is usually no cash back.

Cash back also usually only comes with long term fixed mortgages. We are recommending to generally to stick with variable or 1-year mortgages, and preferring 1-year fixed today.

Ed

corinne
11 years ago

My fiancé and I currently have a fixed open mortgage at over 5% for 40 years and we`re contemplating changing banks (we don`t like the service at our current bank) and taking on a variable mortgage at 25 or 30 years, as well as adding one of our cars to the payments. The penalty for this is 10 000$.

First, I would like to know what other fees may be included that the banks didn`t mention (we are new homeowners and still haven`t quite figured it all out)

Second, I would like to find a bank that offers a good cash incentive to transfer your mortgage to them to help us cover our penalty. Any suggestions?

Last, I noticed that rates are higher for open mortgages, is there an advantage to choosing this over closed if right now we don`t have extra money to put down?

Thanks!

Cor

Ed Rempel
12 years ago

Hi Cannon & Ms Save Money,

We have found it often worthwhile to break a mortgage for a lower rate, especially now. Today, we are often finding that savings in year 1 are as much as the entire penalty.

We are big believers in always staying short term (1-year fixed) or variable, and have been recommending 1-year fixed mortgages now. This is what produces a lot of the savings. In addition to the lower rate, you can save more by converting to a 1-year fixed at the same time.

Today, we are running into a lot of people with mortgages at 4-5%, often with several years left. When we convert them to a 1-year fixed at 2.4%, the savings are 2% or more per year. This is a lot more than the penalty in almost all cases, even when there is a significant penalty.

By sticking with 1-year or variable mortgages, our clients have been getting rates between 4-5% for almost all of the last 15 years. To now be able to get 2.4% is a great savings, even if it is only for one year.

Ed

cannon_fodder
12 years ago

Ms Save Money,

My experience has been that it has never been in my best interests to break a mortgage for a lower rate because the penalties outweighed the potential benefits.

It might be worthwhile for a bank to give you a break on a portion of the fees if you were moving from a short term mortgage to a long term one, especially if the short term was open and the long term was closed.

I think it is safe to say that if the bank is willing to do it, then it is in terms more likely better for the bank than it is for you.

Ms Save Money
12 years ago

breaking your mortgage for a lower rate is always good – the only downside is sometimes you may have to pay a small fee, but in most cases this doesn’t happen.

cannon_fodder
12 years ago

Sampson/nobleea,

Thanks for that. I just checked Canadian Tire’s answer to Manulife’s M1 and NatBank’s All-in-one and their variable portion interest rate is 3.25% as well.

I’m not sure how flexible the readvanceable mortgage lenders such as BMO are, but their posted rate for a 3 year open is 3.75% and a 5 year closed is 3.05%. That means this is the highest that they would go and you might be able to do better. I can’t see that the HELOC portion would be lower than this. When I signed up last year in the summer, we received HELOC at Prime when the mortgages were P – 0.75.

nobleea
12 years ago

I believe national bank has their All in one, which is similar to M1 available to engineers for Prime. i don’t know if they have the monthly fees that M1 does. i think the only stipulation was that you had to pay for their gold mastercard for a year ($75)

Sampson
12 years ago

DAvid, c_f,

The HELOCs I looked into all offer Prime +1%, so the M1 offers no advantages (unless Manulife plans to not increase their prime rate in accordance to BofC rate movements).

cannon_fodder
12 years ago

DAvid,

That depends on WHEN you entered into your variable mortgage. I predict it won’t be until late 2011 at the very earliest before my P-0.75% mortgage reaches 4% at which point I should be mortgage free (but not HELOC free).

For those getting into 2.75% now, I think there are still a good 2 years before rates creep up to 4%.

Jobs are still being lost – the pace of those losses is starting to decline (or is it that people are falling off the unemployment rolls because they’ve been on them so long?). Just last week, our company chopped 5% of staff for the 2nd time in just over a year.

DAvid
12 years ago

cannon_fodder,
Brokered variable mortgages are now available at 2.75%, and RBC advertises Prime +0.8 (likely negotiable), and fixed rates are below 4% (also negotiable). The other big banks should be matching, so there should be many opportunities for folks to start to find good rates.

The unanswered question is: How long will variable mortgages remain below some of the locked-in options?

DAvid