Does It Make Sense to Break Your Mortgage Term?

Interest rates have started to go up. It’s no longer a conversation of whether they will or not, but a fact. The end to historically low interest rates has begun, and it’s time to take notice and prepare. How high they go, or how fast they go up, are the only things that remain to be seen. The Bank of Canada has officially announced its first interest rate hike in 7 years, and it definitely does not look like it will be the last. Now, what does this mean for you? Long story short – the cost to borrow money (i.e. loans, mortgages etc…) will get more expensive. In fact, most lenders have already increased their rates twice within the last month, on almost all their mortgage products, generally around 40-50 basis points (0.40-0.50%). This means, on a $500,000 mortgage, it will cost you $2000-$2500/year more in interest if you got a mortgage today, then it would have if you got it a month ago. This may not seem like a lot for some, but it does add up, especially if you calculate that over multiple years. However, this is just the beginning. Many experts and analysts believe that there will be a regular increase year over year until interest rates ‘normalize’ – essentially, prime rate in and around 6% (we are at 2.95% today, up from 2.70% just over a week ago). This could mean an increase of between 0.50% and 1% per year, or more.

What should you do?

Now, the conversation I’m having with many is in regards to their own situation, and whether it makes sense to break their existing mortgage, pay the penalty, and get into a new extended term at the current (still very low) interest rates. Although there are several different moving parts to this discussion, at the end of the day it generally comes down to dollars and cents – is it worth it?

Let’s use an example. Say you currently have a $500,000 mortgage with a payment of $2533/month, a fixed interest rate of 2.75% and 2 years remaining on it (originally 5 year term and 25 year amortization). The penalty that you pay will depend on who your lender is and the way they charge their penalty - and the difference between lenders can be substantial. To put it into perspective, the penalty can be as low as $3000 or as much as $22,000, depending on the lender. So, the first step in the process is to see how much it will cost to break your current mortgage.

Step 2 is to calculate what you would get on your new mortgage term and how much it would cost you over the new term. Let’s say for arguments sake the rate on a new 5 year fixed is 3.1% (can be higher or lower depending on the lender), which is 0.35% higher than what you’re paying now. Under the new scenario, your new mortgage payment would be about $2610/month (the amortization now would be 22 years as 3 years have already gone by). This would mean that the new mortgage payment will be about $77/month more than what you’re paying now. Also remember, the new mortgage payment is based on $500,000 balance, whereas the original mortgage payment was based on the original balance, which would have been $548,000, 3 years ago. Over a 5 year period, the total cost of the new mortgage would be $156,600 ($2610 x 60 months).

Step 3 of the calculation is trying to make an educated guess or assumption on where rates will be 2 years from now. We also know from history, that rates generally go up faster than they come down, so under the current market situation and the direction things are going, it would be logical and reasonable to assume that rates will go up on average 0.75% per year (which is still not a lot), which would be 1.5% over two years. Therefore, let’s just assume for arguments sake that the 5 year rate in 2 years is 4.60%. This means at the end of the current term, the mortgage balance would be approximately $468,000, and the new payment based on that balance, at 4.60% interest, would be about $2975/month – remember, this is now based on a 20 year amortization, as 5 years have already passed.

Step 4 of the calculation is to see what your total payment over the next 5 years would be if you kept the current course and just renewed after the current term expired. In this scenario, it would be [$2533 x 24 months] (because there’s still 2 years left on the current mortgage) + [$2975 x 36 months] (which would be the payment over the next 3 years after renewal). This comes to a total of $167,892.

Step 5 of the calculation is to see the difference between the amount of payments over the 5 year period, but also taking into consideration the penalty. Using the above examples, over 5 years, you would pay $11,292 more by sticking to your current mortgage and renewing in 2 years’ time ($167,892 - $156,600). Now, to decide if this is really a better option or not, you would add the penalty into the equation. Based on the above assumptions, if the penalty was more than $11,292, then it may not make sense to break the existing mortgage and get into another term, however, if it was less, then the numbers would favour that solution.

Although the numbers are very important to consider, there are also several other factors that should not be overlooked. For example, what is your risk tolerance? If you don’t like the ‘unknown’ or don’t want to gamble on future interest rates, then locking in now for an extended period of time might make sense for you. Also, when using future assumptions of interest rates, you might want to consider over-estimating what the rates actually may be. This is because if you over-estimate, and rates are actually lower, then you will have extra money in your pocket that you could use for other things, such as savings or paying down more debt. If you under-estimate, and rates are actually higher, then it might affect your ability to pay your mortgage or might cause you to be financially tight. Future assumptions are always an important part of the overall Financial Planning process and they should be considered carefully. For example, last November, rates were as low as 2.14% for a 5 year fixed term, and today they’re generally in and around 2.74%-3.29%. That’s an increase of between 0.60% and 1.25% in less than a year. So, if someone tells you that rates won’t go up ‘that fast’, they obviously can, and have.

Variable Rate Mortgages

If you’re in a Variable Rate Mortgage (VRM) and Prime Rate goes up, this generally will impact you more than those who are in a fixed rate. With a VRM, rates can go up or down at any point, even if Bank of Canada does not increase the prime rate – banks are able to set their own prime rate and it does not necessarily have to float/match with the BOC prime rate. A clear example is TD Bank, which increased its prime rate to 2.85% last year even when the rest of the lenders maintained theirs at 2.70. Even now, when the rest of the lenders have a prime rate of 2.95%, TD is still above the crowd at 3.10%.

What this also means is that when rates DO go up, this will affect how your mortgage payment is calculated. For some, this can mean that their payment would increase, which may put them in a very tight financial situation, as their cash flow would get affected. For others, this would mean that less of their payment is going to pay down the principal and more is going towards the interest. This is something very important to understand, as if you’re payment stays fixed, but the amount going to the principal decreases and the amount going to towards interest increases, this can mean thousands (and potentially tens of thousands of dollars) more in interest costs to you over the lifetime of your mortgage. What this also means is that it would take longer to pay off the mortgage than you originally planned or anticipated.

The good thing with VRMs is that the penalty to break them is generally much less than a fixed rate mortgage. With the vast majority of lenders, to break a VRM will just be 3 months interest payments, which can be as much as 1/6th of what it would cost on the Fixed Rate side. VRMs also give you the ability to lock in rates at any time, with that same lender, so if you are staying with that lender, there generally won’t be a penalty. However, that being said, the same lender may not have the lowest rates and best product for you, so in many situations, the better option might be to go to a different lender. One thing to always remember is that, if you have a VRM, and you want to lock the rate in some time into the future, your rate will be based on what the lender is offering at THAT TIME in the future, and is NOT based on what the rate is today or when you had originally got the mortgage. Many people have this misconception that if they lock their mortgage rate in 3 years into the term, they can still get the rate that the lender had at the time of the original mortgage. This is not true, so be careful of anybody who tells you this.

There are also those who previously had a higher rate due to credit or income issue, that might benefit from breaking their term now to get into a new lower rate (if they qualify). For example, using the above scenario, let’s say someone had a rate of 4% instead of 2.75% on a 5 year term, 3 years ago, then it would likely make sense to get into a lower rate if they could qualify. Another example might be of someone who had to take on a second mortgage or private mortgage that they’re paying a high interest rate on (generally can be between 8% and 14%), and they want to refinance to pay off all the other debts. Taking advantage of much lower rates would help them save thousands, even when the penalty is taken into consideration.

Although in the above scenarios it may make sense to break the mortgage and get into a new term, it is not always the best option, and sometimes, not even possible. Some lenders have a stipulation that you can’t pay off your mortgage unless you sell the home, which makes it essentially impossible to refinance and get out of that mortgage, without selling the home.Some lenders have also created their penalty calculation in such a way that it breaking the mortgage term would costs tens of thousands of dollars, and would not make sense. Every lender has their own pros and cons and you should understand all the 'cans' and 'cannots' within their mortgage product before you sign the documents.

Every client situation is different and unique, and should be handled accordingly. There are several different factors that will determine whether it does or does not make sense to break the existing term and get into a new one, and they should be considered in detail before a decision is made. Not all Mortgage Agents are alike, and it is best to deal with someone who is independent, experienced, knowledgeable, and who gives you all the options with their pros and cons. Debt Elimination Planning is an integral part of the overall Financial Planning process, and any steps or strategies that can be taken to reduce the interest paid, reduce the time it takes to eliminate to the debt, or both, should be strongly considered.

If you would like to discuss your own situation and want some guidance on if you could benefit from a lower rate or an extended term mortgage, please get in touch with me.