Breaking Your Mortgage Contract
Low Interest Rates Make This an Option Worth Considering
When my wife and I bought our first house, the interest rate was 7.5%. That sounds awfully high today when you can sometimes see mortgage rates posted for less than 2%. On the other hand, we were buying at a time when housing prices were quite low, much lower than they are these days, so the bi-weekly payments we were making were not more than we could afford.
We never considered breaking our mortgage during those years, but the circumstances of mortgage-paying homeowners today are certainly different than they were 20 years ago.
Why Break Your Mortgage Contract?
The broadest answer to this question is that the terms of your mortgage may no longer meet your needs. If you think you can get a better deal, then you will need to negotiate a new contract, which means breaking the old one.
The Financial Consumer Agency of Canada suggests three reasons you may want to break your mortgage:
- Interest rates have decreased;
- Your financial situation has changed; or
- You are moving and need to buy a new home.
Beware of Fees
Regardless of the reason you want to break your contract, there are almost always going to be fees involved.
Interest Penalty
Let’s imagine that you are two years into a five-year fixed-term mortgage, with 23 years left on a 25-year amortization, and you have found an especially good rate at another lender. Your monthly payments are $1,317. Your current term carries an interest rate of 3.5%, and your lender is not prepared to match the rate of the prospective new lender, which is 2%, so you decide to make the move.
At the lender’s discretion, you are likely to pay a penalty equivalent to three months of interest payments or the difference between the interest rate on your current mortgage versus the current rate for the amount of time that is left on your mortgage (known as the IRD – the Interest Rate Differential). If you started off with a $250,000 mortgage two years earlier, the amount owing would have been reduced to about $235,300, a paydown of the principal of about $14,700. Meanwhile, you would have paid about $31,600 in total, which means that you paid about $16,900 in interest.
If you were to pay three months of interest that works out to a little over $2,000. On the other hand, if you were to pay the difference between the interest rate you are paying now and your lender’s current rate, which for this illustration we will set at 2.5%, the figures work out this way. Under your existing term, you would have spent about $23,300 in mortgage interest over those three years. At 2.5%, you would only have spent $16,400, a difference of $6,900. You can imagine that your lender will elect the second choice.
And there are other penalties as well, in the form of fees for things such as: administration, appraisal, or reinvestment.
Don’t Break It; Blend It
Instead of breaking a mortgage, you can blend the rate you are paying under your current mortgage, with the lower rates that are available now, and get a new lower rate that is somewhere in between. The benefit here is that you do not pay a penalty. There are two versions of blended mortgages.
Blend to Term
Blend to term means you are blending your current rate with a new lower rate, but you continue with the current term of the mortgage. Using the example above, recall that you are two years into a five-year term, meaning the new lower rate will be applicable for the remaining three years. On the face of it, this doesn’t seem like an advantage for the lender. In order to access this type of arrangement, therefore, you typically need to increase the amount you are borrowing. Using an online mortgage blender calculator, assuming the new lower interest rate at the same lender of 2.5%, and additional borrowings of $100,000 for a new mortgage debt of $335,300 for the remaining three years, the new interest rate would be 3.202%.
Blend and Extend
In this case, we are taking the existing mortgage, with three years remaining and $235,300 owing, and rolling that into a new five-year term. Again, the available rate for new mortgage terms is 2.5%. No additional money is being borrowed. The result: for the next five years your new blended rate will be 3.1%. At the end of this new five-year term, the amount owing will be reduced to about $189,100. That means you have reduced your principal by about $46,200 while also spending about $32,800 in interest payments.
Maybe It’s Better to Break It After All
Is blending and extending your mortgage a better deal? Let’s go ahead and break it, adding the $6,900 penalty to the mortgage and an extra $600 for additional fees, for a total of $7,500, bringing the amount owing to $242,800. In exchange, you get a five-year mortgage at 2% from the new lender. At the end of five years, the amount remaining on your mortgage will be about $185,200. Your new, higher principal will be reduced by approximately $57,600 and you will have paid about $21,400 in interest over that five-year term. Despite the additional $7,500 tacked onto your mortgage, at the end of five years, you are $3,900 further ahead than with the blend and extend arrangement.
To be very clear, these calculations are for illustration purposes. I am not a mortgage broker and this blog post is no substitute for doing the “legwork” to see what makes the most sense for your situation. Canadians tend to be loyal to their financial institutions, but when you are borrowing these large sums of money, you owe it to yourself to shop around for the best rate.
If you locked in your mortgage with a higher rate two or three years ago, do not assume that you are stuck there until your current term matures. With today’s low rates, some good opportunities to save money and reduce your debt may lie before you.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax or legal decisions.
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