Refinancing Your Home Mortgage. Is It Worth It?

by Mike Holman

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Expensive house

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.

Refinancing fees

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:

  1. Keep our existing mortgage for 3 years at 5.19% or
  2. 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.

[edit]  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:

  1. Keep existing mortgage for 3 years at 5.19% and then getting a 2 year mortgage at ?% or
  2. 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:

  1. Interest rate is lower, less interest = smaller payments.
  2. 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.

Conclusion

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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{ 21 comments… read them below or add one }

1 Jambo411

One watered down option depending on the length of the mortgage is to blend and extend. Refinance from 3 back to 5 and get a slightly lower blended rate. In a falling interest rate market this makes less sense but if you believe rates are going to rise this is a good option.

2 Mike

Jambo – “Blend and Extend” is an ultra-smooth sounding marketing line but it is just a modified version of breaking your mortgage and getting a new one.

3 Mr. Cheap

Interesting post! I was thinking about doing this a while back (based on the idea that interest rates can’t be much lower than they are now in the future and trying to lock in for a long time), but in the end decided it was too big a hassle for a small (potential) benefit (as you seem to have concluded too).

4 Canadian Capitalist

Mike, did you take into account pre-payment privileges in figuring out the penalties in breaking your mortgage? If I’m not mistaken, FirstLine allows you to pre-pay 20% of your initial mortgage value every year.

5 Mike

CC – I’m not sure how pre-payments would factor into the calculation? Doing a pre-payment is a separate issue from refinancing.

I should have mentioned though that doing a pre-payment (if you have any money) before breaking the mortgage is a good strategy. Even if you have to borrow the money it’s probably worthwhile. Hmmm…that might be worth a separate post.

6 Mike

Actually maybe borrowing isn’t so great – It’s not like you can just get the money out of the new mortgage and pay the loan back.

7 Mr. Cheap

Mike: I think we already did a post on that.

8 Mike

Ah yes – I should start reading your posts. :P

Your post makes perfect sense – I’ll change this post to reference it tonight. It didn’t occur to me that you could just get a higher mortgage to pay off the loan.

I might have to do another post – that certainly changes the refi numbers quite a bit.

9 Sampson

Did you consider maintaining the same payment, despite having a lower minimum.

Certainly you’ll rarely come out on top if you make the minimum payment only, but if you change to a lower rate AND keep the same monthly payment, it’s very likely you’ll come out on top. We will be well over $25k ahead after 5 years (but the pot was sweetened with a cash back offer).

If you don’t maintain the same payments, then you’ll also have to consider the cash saved each month, and the FV of that cash say in a fixed income instrument. By just looking your your penalty vs. interest saved, very close, so add on the extra $$$ saved each month, and its seems the balance would actually sway towards breaking the existing mortgage.

Oh, one final tip, don’t trust the penalty amount until it shows up on the lawyers desk. When we asked our existing lender about penalties, we were quoted one number, which changed a few weeks later, and was also different when the transaction finally closed – all in THEIR favor – jerks!

10 Mike

Sampson – good point. I should have mentioned that yes, I assumed the monthly payment would stay the same.

11 Mike

I just realized that I didn’t add the termination fee to the new mortgage when doing my calculations. This reduces the profit significantly.

In my case if I borrow the remaining prepayment amount then I will end up saving about $650 over 3 years. I’m not sure if that is worth doing.

12 Michael

Found this site to do the calculations:
http://www.ic.gc.ca/eic/site/oca-bc.nsf/eng/ca01817.html#result
After entering in my info I found I would save $150 per month on the payments. save about $2000 over my remaining term of 13 months. and my amortization period would stay the same. My penalty would be about $3500
Not sure if it is worth it at this point, but I am thinking about it.

13 Mike

Michael – If I understand your comment, your penalty is $3500 and the reduced monthly payments will add up to $2000? If that is correct then there shouldn’t be much to think about.

14 Michael

Thanks, for the reply, now if I could only get a confirmation that prime will not increase to 2011 as they say I will be happy.

15 Scott

Mike,

Your estimates assume that the interest rate offered by your bank is almost the same as the interest rate offered by the new mortgage provider.

My differential was calculated as the difference between the current fixed rate (on my mortgage) and the rate being offered on a mortgage equivalent (or close to) what was remaining on my mortgage by the original mortgage provider. In my case 4.89% v. 4.29%.

The real savings came from the difference between the rate used as the differential and the competitor’s rate, in my competitor was offering 3.75%.

Thus saved the (4.29% – 3.75%), ~0.54%, less legal / application fees. In the end I saved about $3500 for about a day of work / running around.

16 Mike

Scott – that’s a good point. I just used ING’s numbers for convenience. I’m sure you could do a bit better (but not a lot better) by shopping around.

How do you figure you saved $3500? What about the termination fee?

17 Scott

The difference in interest over the 3 years remaining was about $9000, (difference between 4.89% and 3.75%). The differential was about 1/2 of that or $4500. After legal fees & termination fee (total about $1,000), that left about $3500 for savings (profit).

18 Four Pillars

Scott – that sounds like a great deal. So I guess the key is getting the best interest rate on the new mortgage.

19 Shawn

Interestingly enough, my wife and I opted to look into a blend and extend option through our mortgage provider (MCAP) this past spring after reading about it on one of the blogs. In our case we were 2 years into a 5 year fixed at 5.09%. By blending and extending we brought our rate down to 4.81% (for 5 yrs) and this knocked our payments down about $35 bi-weekly. Not a huge sum of savings at first but it’s about $4500 saved over 5 years (which we can apply to the principal or other) and it cost us a mere $75 to take that option and the paperwork was 1 page or 2. No legal fees or termination fees required in blending and extending.

If we only look at what we saved for the remainder of our mortage now (3 yrs), it works out to $2700 and unless rates are less than 4.81% in 3 years, then we should be ahead there as well.

Since then I’ve advised several friend to look into such options (B&Ext.) and the common response is “my institution/advisor says it would be too costly to do it” (CIBC, RBC, Van City Credit Union…). Don’t have any figures of what these institutions charged above and beyond the $75 fee MCAP charges to do the same.

Hope this was of value to the post.

20 Mike

Shawn – It looks like you are calculating the savings by the payments which isn’t all that accurate.

Your penalty was the above market interest rate on the 5 year mortgage. 4.81% is quite a bit higher than the market rate of just under 4%.

I’m not suggesting the blend/extend was a bad deal but I doubt it’s much different than a regular terminate/refinance.

21 Leah

What about paying the IRD, refinancing for a much lower rate and reducing your amortization period (drop to 20 years) but still keep your original payments as was suggested by another post – surely you would save money in the long run as you would be paying much more off your principal than you would have with the longer amortization period and higher interest rate. In addition, keep your payments the same as though you were still with the higher rate 25 yr mortgage.

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