Canada finds itself in uncharted territory with historically low interest rates. This has a lot of people wondering if it is worthwhile trying to get out of their existing mortgage and converting into one with a lower interest rate.
We wish we could give you an easy answer and say yes – but unfortunately, it is a case-by-case situation. Yes, rates are historically low and yes you can, in many instances, lower your mortgage payments significantly by converting your current mortgage. But in doing so, you will be faced with what the banks call a ‘pre- payment penalty.’
Banks create pre-payment penalties to recoup the money they expect to lose by renegotiating your arrangement. Borrowers have to remember that when you sign a mortgage, you’re essentially entering into a ‘contract’ with the bank. You are contractually obligating yourself to pay ‘x’ dollars a month over the next ‘x’ number of years. (Our mortgage calculator can give you a more specific figure). In essence, your mortgage payment contract represents an ‘annuity’ or payment stream to a bank which it in turn can sell to a third party investor. This is particularly true for non-traditional banks which ‘securitize’ their funds through the market. So when you come along and decide you want to renegotiate this contract, the bank has to calculate how much it stands to lose in the process and then create a pre-payment penalty to offset the loss.
This penalty can range from three months worth of interest to a much higher amount based on what is called the ‘interest rate differential’ or IRD. The IRD can be a complicated calculation and differs from bank to bank, but in essence it simply calculates the differential between what you were going to pay if you continued with your current mortgage versus what the bank can resell that money for in the current market.
For example, if you have three years left on your current five-year mortgage at 5.79% and you find a better deal with a different lender, your current bank will take the balance of the money owing, determine what rate they can sell that for in today’s market (for example, a three-year term at 4.5%) and then calculate your penalty based on the ‘deemed lost revenue.’ Again, this will be done on a case-by-case basis, and in some circumstances where it is a large mortgage with a lot of time left, the IRD penalty can be significant.
In many instances, it is still worth paying the penalty because the lower rate creates a significant savings, but again, it is case by case.
It is important to note that when we talk about interest rates, there are two different types of ‘rates’ – floating (variable) and fixed. The variable rate mortgage (VRM) is priced based on the prime rate, and the prime rate is affected by the Bank of Canada decisions. Currently, the prime rate is below 3% and is expected to stay there for the balance of 2009. Alternatively, the fixed rate mortgage is priced based on the bond yield. The bond yield is not tied directly to the Bank of Canada and can have more fluctuations.
Today’s market environment presents an excellent opportunity for anyone who is currently in a fixed rate mortgage over 5% with a few years still remaining to switch to a variable rate mortgage below 3.5%. What is particularly intriguing is that there is strong speculation that the bond yields have room to soften over the coming months, which will result in a further lowering of the long-term rates. The key point for borrowers to remember, when trying to compare apples to apples, is that a variable rate by definition is ‘floating’. In other words, you may look at the current prime rate and think it’s fantastic, but remember – prime will not stay that low for five years. It will fluctuate with the market and rise once the Bank of Canada shifts its focus back to inflation.
However, this doesn’t mean that converting to a variable mortgage today has to represent a risk. Virtually all variable rate mortgages (VRMs) allow you to convert to a fixed rate mortgage at no cost at any point in your mortgage term. If predictions hold true, we may very well see the long-term rates hit historic lows within the next year. This will present investors with the opportunity to take a VRM today and get immediate savings over your current fixed-rate mortgage, and then convert into a fixed-rate product (typically locked in at three years) within the next year if they come down any lower – thus locking in your savings.
Of course, everything comes down to the amount of the penalty, and there will definitely be situations where it makes no sense to pay a high fee to switch. Other property owners may be concerned about having to pay the penalty upfront. Even if you do stand to save $20,000 on your mortgage over the next four years, what if you don’t have an extra $10,000 available to pay the penalty today? If you find yourself in that situation, simply capitalize your penalty into your new mortgage – in other words, add the amount of the penalty onto your new mortgage.
Let’s say, for example, the penalty on your existing mortgage is $10,000, and you don’t have that kind of cash kicking around. In many cases, the rates are so low that even if you increased your mortgage by another $10,000 (to cover the cost of the penalty), both your monthly payments and the balance at the end of the term would be lower. If you can afford to keep your payments at their current level, adding the penalty to the new mortgage and lowering the rate will invariably lower the balance at the end of term and may shave years off your mortgage. The only caution with capitalizing your mortgage penalty is that if you switch lenders and change the actual dollar amount on the loan, you may have to have the mortgage re-registered at land titles, and this will trigger legal fees. But again, it may well be worth it.
What to do next?
The bottom line is that with rates this low, it is well worth analyzing your current mortgage to determine if you’re in a position to consider switching. The first step is to call your current lender and ask them how much the penalty would be if you sold your house and paid off the mortgage today.
If you were to perform such an analysis and investigate the options with a broker, they would need the following information:
- Amount of your penalty
- Balance of your mortgage
- Current interest rate
- Current term and how much time is remaining on that term
- Current monthly payments
- Balance owing at the end of your current term
So, take the time to determine this information, and at least have the discussion. It’s worth a quick call. You never know – it could save you a lot of money.
Peter Kinch is a mortgage broker in Port Moody, BC and author of The Mortgage Minute and co-author of 97 Tips for Canadian Real Estate Investors.