Breaking a mortgage for a lower rate?
Breaking a mortgage for a lower rate depends on factors that we’ll discuss below. Reducing the interest rate on your debt, whether it be a loan, a mortgage, or a line of credit, is a no-brainer. However, like all things mortgage-related, it’s important to analyze all potential costs.
Firstly, you’ll want to understand if and how you’ll be subjected to a pre-payment penalty. In most cases, a pre-payment penalty will be the greater of 3 months’ interest and the interest rate differential. You can easily calculate a 3-month interest penalty by multiplying the principal balance by the interest rate, and then divide this figure by 12 and then multiply by 3.
An interest rate differential is based on your current rate, and the interest rate currently available for a new mortgage term, that resembles the remaining length of your existing mortgage term. To make things a bit complicated, different mortgage lenders use different formulas to arrive at their interest rate differential penalty. The banks will usually base their calculation off of their post-rates, whereas broker friendly mortgage lenders might use their actual posted or contract rates. The later is much more borrower-friendly. These, of course, are all important to consider when asking yourself if it makes sense to break an existing mortgage for a lower rate.
Say that you just found out that interest rates have recently decreased, and you have a $400K mortgage @ 3.14%. You calculate that your 3-month interest penalty works out to $3,140. You learn that you might qualify for a rate of 2.69%. Is it worthwhile breaking an existing mortgage for a lower rate?
$400K @ 3.14%, amortized over 25 years, over a 5 year term = $58,123.05 of interest.
$400K @ 2.69%, amortized over 25 years, over a 5 year term = $49,634.13 of interest.
=$8,488.92 savings over 5 years.
Although the $3,140 prepayment penalty, you will be ahead of the game by saving $5,348.92 over the course of 5 years. In some instances, the lender will cover some of the costs associated when you switch your mortgage. That’s money better in your pocket.
On the other hand, if your prepayment penalty exceeds the rate savings, your plans might be delayed.
It gets a bit more complicated in a higher-rate environment, for instance when we look at refinancing second mortgages. If you are able to reduce your second mortgage interest rate by 2%, you need to be certain that the transactional costs do not wash the benefit of the refinance. It might be cost-friendlier to renew the mortgage with the existing lender if origination cost outweighs the renewal fee. In some cases, you might find a need for more money, and the existing second mortgage lender is not prepared to advance you more; you will then need to refinance your second mortgage and find the cost friendliest available solution.
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