Because of dropping interest rates – mortgage brokers have been falling over themselves this year to try to get clients to refinance their home mortgage and get a lower rate. Brokers of course, make money from refinancing, so this is a good deal for them. The idea of having a lower interest rate and being able to lock it in for a while, can be quite appealing for the home owner.
We were contacted a while ago by our mortgage broker about refinancing our mortgage. I was skeptical that there would be any benefit, but of course I wanted to look at the numbers.
This is the greater of three months interest or the interest rate differential (IRD), which is the interest differential payable on the two different rates. Ie if your current mortgage rate means you will pay $10,000 in interest over the next 2 years and you get a new rate which only involves $6,000 in interest, the breakage fee will include that $4,000 of lost interest which the mortgage company won’t be collecting. This breakage fee may seem like a lot if you have a several years left on your mortgage, but it makes sense. Why would a company forgo $X of interest (and profit) by letting you lower your interest rate without charging a fee to cover it?
In our case, we have a five year mortgage. First off – please don’t tell me about how shorter term mortgages are theoretically cheaper over the long time. I’m well aware of that – however in our case it made sense to lock in because at the time we couldn’t handle a large interest rate increase. There are three years left in the mortgage at 5.19%. According to our mortgage company FirstLine – the breakage fee is $4834 + $100 or $300. The $100 fee applies if we stay with FirstLine and the $300 fee is if we don’t. Since we would probably stay with FirstLine, our fee would be $4934.
One interesting strategy is you are planning to break your mortgage is to maximize any amount you can prepay without penalty by borrowing the money and then paying it back with the new mortgage. You can read more about how to save money when breaking a mortgage.
Do we save on interest?
One scenario I looked at was:
- Keep our existing mortgage for 3 years at 5.19% or
- Break the mortgage and get a 3 year fixed mortgage at 3.59% (taken from ING site). The idea is to directly compare the benefit over 3 years with known rates. I calculated that the interest savings would be $4675. In other words the breakage fee will exceed the interest saved by $259. As previously mentioned – this makes sense since the mortgage company is not going to voluntarily give up profit that is already under contract and if they can make some extra money they will do it. I didn’t get a quote from FirstLine or anywhere else for a better rate so it’s quite possible that the interest saved might be slightly more than my example.
Conclusion – Not worth doing in this situation. The breakage penalty is roughly equal to the interest saved.
 I forgot to include the amount of the breakage fee which gets added to the mortgage. This amount will accrue interest and will lower the profitability of refinancing.
Refinancing can lower your interest rate risk
Another scenario is:
- Keep existing mortgage for 3 years at 5.19% and then getting a 2 year mortgage at ?% or
- Break the mortage and get a 5 year fixed at 4.15% (from ING).
One other benefit of breaking your mortgage is to lock in a great rate for a longer time period. This made a lot of sense a few months ago because the long term rates were so low. If we did that strategy then we would break even or lose a bit in the first 3 years. However if interest rates were to go up over the next few years then we would make a profit because the last 2 years would be locked in at 4.15%. Had we kept our original 5 year deal in that case the interest rate paid on renewal would be much higher than 4.15%.
The problem is that to do this calculation you would need to know what the 2 year fixed mortage rate is, 3 years from now. Is it lower, the same, higher, a lot higher??? You can create all the spreadsheets in the world, but it’s still a guess which is why I didn’t do an actual calculation for this scenario.
We are aggressively paying down our mortgage and will hopefully be done with it in about five years. What this means is that in three years, our outstanding balance won’t be all that large, so the risk at that time from higher interest rates is not that meaningful since our payments would still be quite manageable, even if rates were 10% or higher.
Jump to shorter terms and lower rates
Another strategy for refinancing is to go from a fixed long term mortage to a shorter term or even variable term mortgages which have lower rates at the moment. This is another strategy where you are basically trying to predict the direction and timing of interest rates. If you are successful, you might save a lot of money – if not…well that’s too bad.
Historically low rates
What if you don’t have a lot of time remaining on your existing (large) mortgage and would like to lock in for several years? Given the low rates available it might make a lot of sense to break the existing mortgage and lock in the low rates. Locking in for 5 years, gives you time to pay down the mortage without worrying about a big interest rate reset during that time.
Don’t get sucked in by lower monthly payments
One tempting aspect to getting a lower interest rate on your mortgage is the possibility of lower monthly payments. This could occur for two reasons:
- Interest rate is lower, less interest = smaller payments.
- You can reamortize the mortgage and start your amortization period from zero again. Ie if you are 5 years into a 25 year mortgage and you refinance, you can restart your 25 years amortization which will result in lower monthly payments.
The problem with #1 is that you end up paying the extra interest anyway in the form of the termination fee, so you don’t really save anything. #2 is just bad – you are just turning your original 25 years mortgage into a 30 year (or longer) mortgage.
I think it would be easy for someone to renegotiate their mortgage, pay the termination fee, end up with lower monthly payments and be congratulating themselves several months later (having forgotten about the termination fee) on their clever financial engineering (“Hey neighbour, I refinanced and saved $200 per month”).
If you get pitched by a bank or mortgage to refinance in order to lower your monthly payments, run the other way. They might also be suggesting switching to a shorter term to get a lower interest rate. Yes, you will save in interest, but a 1 year term or variable mortgage won’t stay cheap forever and if rates go up, your payments will rise accordingly.
From what I can tell, there are no direct savings from breaking a mortgage and it might even cost you a bit. The mortgage company will charge a fee to make sure that for the time remaining on your original mortage – their profit will stay the same, which means you don’t save anything. The only way you can benefit from breaking your mortgage is to make an accurate call on future interest rates. One such situation is if you are getting near the end of your fixed mortgage and there are historically low rates available. It would be hard to go wrong in that situation to refinance your mortgage assuming you want to stay locked in.
You should also consider negotiating to get a better breakage fee. I don’t know if mortgage companies will bend on this, but you never know.
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