The relentless onslaught of the coronavirus pandemic has had serious consequences for the Canadian economy. In the initial days, the economic contraction prompted the Bank of Canada to cut its overnight rate to 0.25% to support the national economy. A by-product of this move has been the ultra-low mortgage rate environment, prompting the Big Six banks to slash their advertised five-year fixed mortgage rates, most of them are now close to or lower than 2%.
Record low rates and BoC’s low-rate-for-long outlook are creating a dilemma for many homeowners currently locked in a considerably higher fixed-term rates. Which leads us to wonder, ‘Should I break my mortgage?’ But will it make sense after paying all the penalties for breaking the mortgage early?
Number-Crunch
It takes some serious number crunching as part of cost-benefit analysis that considers the steep penalties lenders impose relative to potential savings. “Look at how much it’s going to cost you to break your mortgage -- the mortgage penalties and any fees --versus your interest savings by breaking your mortgage and going with a lower rate today,” says Sean Cooper, mortgage broker and bestselling author of Burn Your Mortgage. “If you’re going to be saving money before the end of your term by switching, that’s when it can make sense.”
For example, he adds, if you have three years left on your term, comparing the savings over those three years, minus your penalty cost will show you how much you come out ahead.
Also Ask ‘Why?’
Penalty is number one but not the only consideration, cautions Joe Jacobs, managing partner with Mortgage Connection in Alberta. “You might also have other needs such as increasing monthly cash flow, higher debts you want to consolidate,” he says, noting “a review of all your finances should be considered. Sometimes the penalty is too high, you may not have the ability to add it back to your new mortgage and may not have the resources to cover it out of pocket. If any of the above is the case, then staying in your existing mortgage may make sense.”
A borrower also needs to figure out why they want to break their mortgage, Cooper says. A life event leading to a dramatic change in personal finances, for instance, could be one of the triggers. “If you’re finding it tough to make your regular mortgage payments due to COVID-19 or you’ve taken on new consumer debt, then you might choose to break your mortgage and refinance it to stretch out your amortization period to make your regular mortgage payments more affordable,” says Cooper.
Conversely, there could be a situation where breaking a mortgage may make sense even if it won’t result in saving interest. “For example,” says Cooper, “if improving your cash flow is the main reason, you might choose to break your mortgage, even if you won’t be saving any interest.”
How Does the Math Work?
How does mortgage math work when it comes to terminating the contract prematurely? All mortgages and penalties are not created equally, experts say. Big Bank mortgages have some of the highest fixed rate penalties, use complex calculations and employ different methods designed to compensate lenders for lost interest payments.
To illustrate how the math works, Cooper does a back-of-the-envelope-calculation. Let’s assume someone with $350,000 in mortgage balance is two years into a 5-year fixed term mortgage at 3.5% rate, looking to take advantage of a 1.95% current mortgage rate. There are three ways to calculate their potential penalties.
Method 1 – 3-month penalty
Formula: Contract Rate × Mortgage Balance × (3 months/12 months) = 3-month penalty
Example: 3.50% × $350,000 × (3 months/12 months) = $3,062.50
Contract Rate = The mortgage rate you're currently paying on your mortgage
Method 2 – Interest Rate Differential (IRD) with discounted rate
Formula: (Contract Rate + Discount to Posted - Current Rate) x Mortgage Balance x (Months Remaining/12) = IRD with discounted rate
Example: (3.50% + 0.5% - 2.69%) x $350,000 x (36/12) = $13,755.00
Discount to Posted = The discount you received off the posted rate when originally signed up for your mortgage
Current Rate = The current rate that most closely matches your remaining term (i.e. the 3-year fixed rate in this example, since you're 2 years into a 5-year fixed rate mortgage)
Method 3 – IRD with posted rate
Formula: (Posted Rate - Current Rate) x Mortgage Balance x (Months Remaining/12) = IRD with posted rate
Example: (4.79% - 2.69%) x $350,000 x (36/12) = $22,050.00
Posted Rate = The posted rate when you originally signed up for your mortgage
Potential Savings:
[Mortgage Balance x (Contract Rate - New Contract Rate) x Years Remaining] – Mortgage Penalty = Mortgage Savings
[$350,000 x (3.50% - 1.95%) x 3] - $13,755.00 = $2,520.00
The above calculation shows the potential savings with the IRD with discounted rate (Method 2) when breaking your mortgage to go with a lender offering 1.95%. In this case it would make sense to break your mortgage since you’d be saving over $2,500 over 3 years by doing so, Cooper concludes.
Lowest Rates, Highest Penalties
“All lenders are required to have pre-payment penalty calculations on their website, so start there,” advises Jacobs, stressing homeowners could also contact their mortgage broker or lender and get a quote. It is important to note, he adds, “all [penalties] are subject to change and we have seen big jumps with rates falling.”
In other words, a penalty quote today may be higher tomorrow. “In general, falling rates create a bigger spread compared to your existing mortgage and thus a larger IRD,” says Jacobs. The flip side to the lowest rates of all time, therefore, is some of the largest penalties of all time. There’s often going to be double-digit penalty fees “even [with] lenders that have the fairest calculations,” he cautions.
Variable Vs Fixed
It must be noted that penalties are different for breaking a variable mortgage versus fixed. “Most variable rates are three months of simple interest and most fixed are the greater of three months of simple interest or IRD (calculated differently depending on your lender),” says Jacobs, stressing that “the variable is clearly the winner on penalty calculations.”
If you are breaking a fixed mortgage, though, “it can be downright nasty,” particularly when rates are dropping, he warns.
“The IRD is supposed to compensate lenders for lost interest, but can seem punitive in nature with some lenders, mainly the banks who use their posted rate when calculated the IRD,” says Cooper. “If you like fixed-rate mortgages, there are ‘fairer penalty lenders’ out there that generally offer lower penalties when breaking your mortgage.”
It may be a good idea to tap a mortgage broker who has access to these lenders, he adds.
More than Rates
That said, cost is not always just the rate. Flexibility and lower breakage fees should be a major consideration. “The biggest mistake is being solely focused on the rate when signing up for a mortgage,” says Cooper. “While the rate matters, other things like penalties matter, too, maybe even more than the rate in some cases.”
He goes so far as to say sometimes it can make sense to take a slightly higher rate if it means a substantially lower penalty if you have to break your mortgage later on. What if the borrower can’t pay the mortgage penalty out of pocket? “That’s no problem,” says Cooper, adding, “most mortgage lenders let you add up to $3,000 in penalties and fees when breaking your mortgage.”
For those who incur larger penalties, as is the case with most borrowers in a fixed-rate contact, there’s a workaround, provided they have a good credit standing and at least 20% equity in their home. It’s called mortgage refinancing. “If the penalties and fees exceed $3,000 and you can’t afford to pay them out of pocket, you can refinance your mortgage and add the penalty and fees on top of the new mortgage so you don’t have to pay anything out of pocket and deplete your savings,” says Cooper.
When in doubt, ask for advice. Breaking a mortgage is a major financial decision, it is advisable to contact a professional who can look at your individual financial circumstances and offer the best course of action based on a cost-benefit analysis.
