Anybody who bought their first house in the 1980s
must marvel at mortgage rates today. Or perhaps fume.
All of the major financial institutions have had their prime
lending rate at the record low of 3.00%.
Consumers who locked into variable-rate mortgages tied to prime
before credit markets tanked are getting as much as 90 basis points
below prime and borrowing as low as 2.10%. It's the deal of the
century.
In October 2008, the banks suddenly changed the rules on borrowing and
demanded consumers pay a 100-basis premium over prime if they wanted
to go variable. The banks have eased up since and we are back to a
variable-rate product of up to .40 basis points below prime for a
2.60%
rate. (5 year term)
It poses an obvious question for anyone who has
locked into rates as high as 5.75% on a five-year fixed-rate
mortgage: Should they break that mortgage?
It probably does make sense to break it now. One example of a client
who hand a $205,000 mortgage and a 5.24% interest rate. The customer
had 3½ years left on a five-year mortgage. The penalty to break his
mortgage is the greater of three months interest or what is called
the interest rate differential. The interest rate differential is
the lost interest between your current rate and market rates. In
this client's case, his interest rate penalty is calculated based on
the current four-year rate at his bank, now 4.14% on a discounted
basis. The lost interest to the bank is about $7,800, which is what
the customer will have to pay. It's a big penalty but if that same
customer breaks his mortgage and goes with the variable-rate
mortgage at 2.10%, the savings would be over 5,000 each year!! -- more than offsetting the penalty.
There is also a nifty little trick you can pull off if you have a
prepayment option on your mortgage. This customer has a 25%
prepayment privilege, so he can knock $57,000 off their mortgage and
lower the penalty by about $2,800. You can access [that 25%] from an
unsecured line of credit or some credit cards for a few days and
reduce your penalty because the penalty is based on the balance
outstanding. In some cases its as simple as having the Notary or
Lawyer issue two cheques, one for the 25% prepayment and the
remainder to pay the balance.
This is where expererience and having someone working on your side
counts. Part of my service includes reviewing your documents
and to outline what options are contractually available to you.
While not encouraging people to break their mortgages, the banks are
acknowledging that some consumers who locked into higher rates can
save money if they refinance at the new lower rates.
It does make sense as an option for some people trying to lower
their rate. If you are refinancing your mortgage, you can take the
interest rate differential penalty and tack it on to your new
mortgage. If you have credit card debt, you can add that on too, and
the refinancing makes even more sense. It ultimately comes down to
how much money you will save on your mortgage if you break the
contract.
To me, it's pure mathematics. There is nothing speculative or
probabilistic about the decision to break a mortgage. It is the
classic example of undergraduate finance time-value-of-money
calculations. If the homeowner can refinance into a mortgage with an
identical term that reduces monthly payments above and beyond any
penalty costs, then go for it. Plain and simple!
Breaking your mortgage based on a decision to go into a
variable-rate mortgage is an entirely different decision.
This decision shouldn't be confused or muddled
with the classic long or short decision, or whether real estate
prices or interest rates are headed up or down from here.
So, it comes down to two choices:
The first is to break your locked-in
mortgage and renew for another fixed term.
If it saves you cash, that is a no-brainer.
The second choice is whether to switch products and go with a variable-rate mortgage. Historically, consumers have saved money 88% of the time going variable, according to studies.
I'm still in the camp that favours a variable rate, however this does depend on your unique circumstances.
This will not save you any money, but if you are
strapped for cash because one of the breadwinners in your home has
lost a job, the banks will let you lengthen your amortization
period. If you have a 25-year amortization you can lengthen it to 30
years typically without any service charges -- other than the huge jump in
interest charges over the life of the mortgage!
