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
- 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
- Biweekly payments – you do this right? If not start today.
- Maximize prepayment options
- Increase biweekly payments (anywhere from 0-20%)
- Make annual lump sum payments
Here is an example of the potential savings (without considering the penalty)
- 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)|
|> $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!
Here’s another opinion by Colourful Money.