How To Lower Your Mortgage Interest Rate Without Paying Any Penalties

by Mike Holman

One of the many challenges of owning your own home is the decision between a variable rate mortgage or locking in for a longer term. Currently, the variable rates (2.2%) are significantly lower than the 5-year fixed rates (3.8%), so going variable is very tempting.

But what if interest rates shoot up?  Then the fixed option might end up being cheaper.  It’s a tough decision without a crystal ball available.

When my wife & I renewed our mortgage almost four years ago, we decided to get a 5-year fixed rate mortgage with an interest rate of 5.19%.  We chose a fixed-rate mortgage so we wouldn’t have to worry about increasing interest rates.  At the time, our budget was a bit tight and the last thing we needed was higher mortgage payments.

Of course, interest rates continued to decline after we locked in.  While I wasn’t too annoyed since we locked in for a good reason, it was still a bit aggravating to think about how much money we could have saved with a variable mortgage.

Luckily, I came up with a face-saving method to lower the amount of interest we were going to pay by making use of our line of credit, as well as our fixed mortgage prepayment option.

Our home equity line of credit (HELOC)

Along with our fixed mortgage, we also have a home equity line of credit (HELOC) which has an interest rate equal to the prime rate (currently 3.0%).

When I first got the mortgage, I was using the HELOC to borrow money for my Smith Maneuver attempt, which involves borrowing money to invest in the stock market.  When I ended the Smith Maneuver in the Fall of 2009, this freed up my HELOC and I could use it for other purposes.

The mortgage prepayment option

Our fixed mortgage has a generous annual prepayment option, which is equal to 20% of the original mortgage value.  In our case, that annual prepayment amount was $40,800.  This means that we could make lump sum payments against our mortgage principle at any time totalling up to $40,800 per year.

We’ve never come close to using the maximum prepayment amount, since it’s just too much money.  But it occurred to me that this large prepayment feature could be used in conjunction with our HELOC to lower our effective interest rate.

The solution – use the HELOC to pay off the fixed mortgage

Every August, when a new “prepayment” year started, we made a $40,800 withdrawal from our HELOC and paid down the fixed mortgage by $40,800.

In the first year, this resulted in converting $40,800 of our 5.19% mortgage to the 3.0% HELOC for a saving of $893 in interest.

In the second year, we moved another $40,800 and saved $1,786.  We saved $2,679 in interest over two years.

In our case, our mortgage wasn’t big enough to continue the huge annual pre-payments.  We will be doing our last prepayment this August for about $20,000 and that will be the end of our fixed rate mortgage.

However, we will still be saving each year by having all the mortgage in the HELOC instead of the higher fixed mortgage.

Savings are not guaranteed

The way I’ve described this method, makes it sound like easy money right?  Not so fast.  The only reason we’re saving so much money is because the interest rate on the HELOC is significantly lower than our fixed mortgage rate.

If the HELOC interest rate rises, the interest costs will be higher on the HELOC and our savings will go down.  Worst case scenario is that the prime rate goes over 5.19%, at which point we will end up paying a higher interest rate on the HELOC than on the fixed mortgage.

I’m not predicting that interest rates will stay low forever, but I do think that it will take a while for the prime rate to surpass 5.19%.

Why not just break the mortgage?

If you are stuck in a high interest mortgage, there is always the option of breaking the mortgage and getting a lower rate.  The problem is that the banks will charge you a fee to make up the lost profit on the terminated mortgage.   Ellen Roseman recently wrote an excellent article on these fees called How to reduce the pain when you break a mortgage.  Here is another article I wrote which analyzes if it is worthwhile to refinance your mortgage (hint – it probably isn’t).

Don’t forget to pay off the HELOC

One of the biggest risks of this plan is forgetting to pay off the HELOC balance once the fixed rate mortgage is gone.  Unlike a fixed rate mortgage which has a defined amortization period and requires principle payments along with interest every month, most HELOCs only require a payment large enough to cover the interest.

It is very easy to just make the minimum interest payment each month and enjoy the extra cash in your pocket.

Once your fixed-rate mortgage has been completely converted to the HELOC, you should make total monthly payments equal or larger than the amount you used to pay on your fixed-rate mortgage.  This will ensure the HELOC balance will get paid off in a reasonable amount of time.

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