When to break your mortgage term

Rebecca Awram

A regular enquiry that I receive is from clients only part-way through their term that would like to take advantage of refinancing into a new term with a lower interest rate. Seems like a no-brainer, right? Not always! Almost all closed mortgage terms come with penalties to ‘break the contract’ and pay out early.

The penalty will depend upon your mortgage

Mortgage lenders will charge you a penalty to break your term/contract with them. If you have a variable rate mortgage, the penalty is three months interest. If you have a fixed rate mortgage, it will be either three months interest, or an ‘interest rate differential‘ calculation, whichever is higher (of course!). The IRD equation is different among lenders, but basically is intended to compensate them for the loss of re-investing your mortgage dollars at a new, lower rate. Every lender has a somewhat different equation that they apply, so you must contact your current mortgage lender to get the exact penalty amount.

house on a chart showing fluctuating mortgage ratesEssentially, in times of decreasing fixed mortgage rates, IRD penalties can be quite high. During periods of flat or rising fixed rates, it is likely that just the three month interest penalty will be applied. The penalties can seem unfair, but keep in mind that you are asking the mortgage lender to break a contract with you. If it were the other way around, and they wanted to break the mortgage contract with YOU because rates were rising and they could invest that money somewhere else for more money, that probably wouldn’t go over so well with you! The numerous complaints about these penalties tend to cluster around the fact that IRDs weren’t explained properly at the time of signing, and also that there should be one universal equation to determine them. Some organizations and individuals have lobbied the Canadian government to do something about this.

Once you know the penalty amount, your mortgage advisor can work out the math on your situation to let you know if you would save money after paying the penalty. For example, if you’re currently paying a fixed rate of 5.5%… but can re-finance for 3.49%… the monthly savings may add up to considerably more than the penalty. Alternately, the penalty could be higher than the savings. Every case is different, so consult a professional! Often you can add the penalty to your new mortgage, so that there is no out-of-pocket expense. Additionally, if you have unsecured debt at substantially higher interest rates that you can roll into the mortgage, the savings are compelling (think: credit cards, lines of credit, car payments, etc).

Many people are choosing to get out of their variable-rate mortgages right now with an eye to future increases in the prime rate, especially if they have a small margin (i.e. prime minus .20 or less). This creates an attractive time to lock-in historically low rates. Even though no one can accurately predict the moves of the Bank of Canada, we cannot dispute the attraction of 5 year fixed rates that are around 3% with most lenders at the time of writing.

Should you break your mortgage term?

The decision to stay or go is intensely individual. There is no one answer, as everybody’s penalties and potential savings are different.  There is no obligation to contact your mortgage broker and find out how this might save you money.

 

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