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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{ 17 comments… read them below or add one }

1 James

A catchy title however I it is unfortunate to find another article that would make people think that their mortgage payments will rise with interest rates in a variable rate mortgage. The portion of your payment that reduces your mortgage principal will change as the interest rate changes in a variable rate mortgage. Only when that portion drops below a certain threshold would the bank want to talk about changing your payment.

However, there is an easy way to avoid this problem: when setting up your mortgage, ask the bank to set your payment amount higher than it would be for the current variable interest rate. I generally calculate what my payment would be at an interest rate 2-3% higher than the current rate. This way, you pay the mortgage off faster, and have even less to worry about if the rates increase.

Since you were willing to accept a 5.19% fixed rate, why not simply get a variable rate mortgage but set the payment amount as if the rate was 5.19%?

That way, you get to keep the proceeds if interest rates are low instead of the bank, and if interest rates do rise to 5.19% (or slightly beyond, because you would have saved so much money early in the mortgage) then you’re no worse off than today.

Your article is a good idea for those who might not have considered using their HELOC this way, but I think you should note two things clearly:

1. Using the HELOC to prepay the mortgage essentially converted the fixed-rate mortgage into a variable-rate mortgage. So if people have issues with a variable-rate instrument, they should understand clearly that this is what they are getting into.

2. The HELOC interest rate is likely not to be better than prime, whereas four years ago and today variable-rate mortgages could be got at prime – 0.8% (though for a while in the interim those deals were less accessible).

Good tip, and your site is definitely on my must read list.

2 Bruce

While you touched on this in the last paragraph, I would be sure to mention that this method of paying less overall interest is highly dependent on each person’s cash flow situation.

If your mortgage is like mine, then making the yearly bulk payment does not reduce the payments you make on the primary mortgage. Therefore you are reducing the amount of cash flow available to you every month, and are essentially locked in to that higher payment for a year. Fine in normal situations, but it seems a little risky, especially if the emergency fund is not equal to the amount borrowed on the HELOC if you need to maximize cash flow for what ever reason later.

With my mortgage, we can always double the payment and reduce the principle portion by that amount. With interest being calculated bi-annually on Cdn. mortgages, does that not reduce the overall interest paid by a similar amount, with more freedom to return to the regular payment if our cashflow situation requires it?

Just a thought, If I get a chance to run a spreadsheet of the two scenarios I will report back.

Thanks for the Blog!

3 Mike Holman

@James – I have a 5-year fixed contract. I can’t just switch to a variable without paying a big penalty. This strategy allows me to gradually switch to variable without paying any penalties.

@Bruce – Good point. In my case, I can lower the monthly payment amount on the fixed mortgage to make up for the extra interest payment on the HELOC, so I could have kept my cash flow the same had I wanted to.

I don’t think doubling the payment will have the same effect. In my case, I moved a chunk ($40,800) of debt from 5.19% to 3.0%. Even if I were to keep the total monthly payments the same as before, I’m saving a lot of interest which means the mortgage is getting paid off faster without increasing monthly payments.

Of course making extra payments (doubling) will also save on interest, but it also takes more money. It’s really a separate strategy.

In fact, I basically did both strategies – move money to the LOC and make extra payments which is why the mortgage will be done next year.

Thanks for the great comments.

4 Patricia

Hi Mike.
Can you tell me which bank is offering HELOCs at prime? I have two LOCs at TD (both rentals) that were originally at prime, then a year or so ago TD arbitrarily raised them to prime + 1%. I recently saw an RBC ad to switch LOCs to them, they’ll pay the switching costs, and their rate is prime +.5%. I was just about to make an appointment with TD to find out what they’d do to keep me as a customer when I saw you mentioning an HELOC at prime….
Thanks!

5 Mike Holman

@Patricia – As far as I know, none of them are offering prime. I got my HELOC about five years ago when they were available.

6 Derek

So assuming your still carrying a Heloc balance after finishing the mortgage in August will you take that Heloc balance and convert to a traditional mortgage (2.2% variable) to save again or will both Heloc and mortgage be done?
Couldn’t really tell from what you wrote.

thanks
D

7 Mike Holman

@Derek – Great question. I didn’t address that at all in the post.

In my case, in August we will have no fixed mortgage and all the mortgage debt will be in the HELOC. We will be leaving it in the HELOC and just paying it off from there.

I should note, we are down to less than $20,000 which will be paid off sometime next year. I have no worries about interest rate risk for that money and I don’t want to bother with a variable rate mortgage.

If this strategy is implemented and the HELOC ends up being fairly large, certainly converting it to a (lower) fixed rate mortgage might make sense.

8 Derek

Ok Mike.

all makes sense so far. So how many years in total then did it take to pay off your original $204,000 mortgage? One more nosey question.. at what age did you take on this mortgage?

Based on my understanding from your article you paid down your mortgage in the past 4 or 5 years at a clip of $20-25k per year in principle?

Did you ever figure out what % of each $1 you paid was going to principal in the last few years?

good show on the mortgage elimination.

D

9 Mike Holman

Hi Derek.

We started the $204k mortgage exactly five years ago when I was 37. Keep in mind that it’s not really completely paid off – the remaining $18k or so is now on the HELOC.

Once the HELOC is at zero, then the mortgage will be done. It will have taken about six years or maybe a bit less.

Yes, I have a spreadsheet which shows the % of payments which are going to principal. It was encouraging to see this number increase over time.

10 Mika

Sorry but reading change to an adjustable rate makes me want to vomit.
I purchased my first house over 25 yrs ago w/Citi Corp & when we went for mortgage we were between a fixed rate & an Adjustable rate. They talked up the Adjustable rate to be so much better & that if we wanted we could change over to a fixed rate at anytime no problem. WHAT BS!! First off the adjustable rate was explained that it would only go so high.. & would never go to max…well we got BS’d.
Our mortgage started out at $929.00 a month within a year & half it went over $1400.00 it was out of control & when we called our Mortgage co. to switch to a Fixed rate we were told we didn’t have enough equity in the house to do so. Finally after nowhere to turn & continuos rising rates we declared bankruptcy & walked away from the headache. Bottom line BEWARE of what you’re getting in to.
At least with a fixed rate you have the peace of mind what your payments are.

11 Rob, Canadian Mortgage Trends

Hi Mike,

A few of our clients have done what you suggest when their penalty makes breaking/refinancing unfeasible. As Bruce notes, the borrower must typically service both the regular mortgage payment plus the new line of credit (LOC) payment.

Generally, it’s most cost-effective if the fixed mortgage is inside a fully readvanceable line of credit that supports variable-rate mortgages.

In that case, you can immediately convert the new LOC balance to a deeply discounted variable-rate mortgage (instead of paying the higher LOC rate).

As an added benefit, the best readvanceable mortgages have a LOC limit that increases automatically when you prepay the mortgage portion(s). That gives you a backup source of cash if you really need it, which allows you to make aggressive prepayments and still keep liquid.

Examples of fully readvanceable mortgages that let you lock in HELOC portions to a discounted variable rate include:

* National Bank of Canada’s All-in-One
* RBC’s Homeline
* Scotia’s STEP.

Cheers,
Rob

12 Mike Holman

Hi Rob – I think that’s great advice to convert the LOC balance to a discounted variable-rate mortgage. However, in my case the balance is quite small ($12,000), so I’d rather just leave it and pay it off fairly soon.

13 Rob, Canadian Mortgage Trends

Hi Mike,

Gotchya. That makes sense. If you plan to pay off a small balance faster than normal prepayment privileges allow, then an open LOC is certainly better than a closed variable.

There’s a quick rule of thumb based on current rates. That is, put what you plan to pay off within six months in an open LOC. For any amount you won’t pay off in six months, put it in a closed variable mortgage. Even if you pay a penalty for early termination, that usually saves you money versus paying the higher rate of an open.

Cheers…

14 Jo-Anne

Hi- I have a HELOC with TD. It is $424K with a fixed payment portion of $406K at 4.18% interest. I currently have a balance of $359K on fixed portion and 2 years left of fixed rate at %4.18. I asked the bank today what is the penalty to close this and tale advantage of the new %2.99 rates. The penealty was a shopping $15k! So bank suggested I take the equity I have of $60k and use $60K to pay down fixed portion at %4 and the 60K I used to pay down fixed portion would be at 2.99%. That would mean I would be servicing the fixed portion at 4.18% but it would be down to $299K and then I would need to service the $60K at 2.99%. SHOULD I DO THIS?? IS IT WORTH IT? I AM CONFUSED. My ultimate obejctive is to get rid of my GD mortgage but I do have kids about to go to universtiy…….. I feel like I have paid the bank so much interest since I first took out a morgage in 1994 for $24oK. Any feedback advice…..so much appreciated. Just waking up now to understanding this game.

15 Mike Holman
16 km

Hi Mike,

Thanks for the article. Here is my situation.
I have the National Bank All-in-One with a variable mortage at prime -0.4%, LOC at prime +0.6%. Current mortgage balance is $110k.

My broker suggested this strategy to chip away at the mortgage. Take $5k from the LOC and pay a lump sum towards the mortgage. (The LOC is my main acct where my regular income direct deposit goes.) When the LOC balance goes back to $0, take out another $5k. Will this save me money?

Thanks,
KM

17 Mike Holman

KM – I don’t see why you would want to borrow from the LOC with the higher interest rate to pay down the lower interest rate mortgage.

Makes no sense at all.

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