Refinancing to save money

Now that the Canadian Lenders have followed the Bank of Canada’s lead and dropped their prime rate by .50% to 2.50% not only is the variable rate coming down but so are the fixed rates. Every day it makes more sense to take a look at your mortgage and see what re-financing would save you. I will do my best to break down the components to try and simplify this for you.

First of all, let’s take a few things for granted:

1) you are currently maintaining a good credit record

2) your job/income is stable and reliable

3) the value of your property is such that you currently owe less than the property is worth.

On a simple re-finance to get a better rate and save money on interest, you first need to determine what your pre-payment penalty is.

In just about every mortgage, the lender has the right to charge the greater of “Interest Rate Differential” or “three months interest”. “Interest Rate Differential” or IRD is calculated usually determined by most lenders by the difference between the posted rate at the time you took your mortgage and the current posted rate. You may have gotten a discount at that time. It doesn’t matter, they will probably use the posted rate.

So, for example, say in March, 2007 the posted rate at your lender was 6.79% and the posted rate today is 5.79%. The difference is 1.0%. If you took a 5-year mortgage, you would then have 3 years left. If your current balance is $200,000 then multiply that by 1.0% by the remaining 3 years of the term = approximately $6,000. Depending on the amortization chosen at that time will determine the decreasing balance and actual amount of the penalty.

For the sake of this exercise, let’s say it is $5,500. Now, the same mortgage, three months interest would be based on the rate you actually have on your mortgage. Let’s say it is 5.35%. Therefore, 3 months interest would be $200,000 multiplied by 5.35% (one year’s interest) = $10,700 divided by 4 = $2,675 (3 months interest). Again allowing for a decreasing balance and your penalty may be in the range of $2,550. That means the lender would have the right to charge the $5,500. I say “the right to charge” because you may be able to negotiate this penalty down with what you would offer in return for a re-financing package. And that may consist of the increase in mortgage dollars you are going to be borrowing.

Once you have determined your penalty, then you need to know what your current balance is, add any discharge fee (usually $75 – $150) and legal fees to register the new mortgage (&750-$1000). Now you know what your new mortgage will need to be.

Using an amortization table you can determine what your balance will be as you pay your new mortgage down. Now if you want to truly compare the savings, use the payment you have been making on your original mortgage. Same payment, lower interest not only means you are paying less interest but the amount being paid on the principal is more so you are ultimately paying your mortgage off much faster. Compare the amortization schedule from your original mortgage to the new mortgage to determine your savings.

You can also calculate in savings against future increases. Remember, your original mortgage term will have to be renewed in two or three years and the rates will be higher again. These lower rates won’t last forever. So your new mortgage at the lower rate will carry on for two or three years longer and the savings will be all the more.

Now, if you really want to save money and still pay for your home quicker, consider your personal debt. Any loans and credit cards you may be paying 12 – 18% or more on. Remember, thinking that you are safer by having less debt on your home only works if you don’t owe any personal debt. And if you owe money, you will have to pay it all back. The key is to pay less interest. Transferring $25,000 of personal debt at a rate of 15% to your mortgage can easily save you as much as $5,000 in only three years (11% difference on an average balance of $15,000). If you are paying $750/month on that debt you can simply add that to your mortgage and your personal debt will be paid off just as quickly as if you kept the personal debt separate from your mortgage. Using the examples I have suggested here savings can add up to as much as $15,000.

Now, these ideas above are for the individual who has equity in their property and has the cash flow to make their current payments. But what if you have had a cut in income or are concerned about a future cut in income and are just looking to cut down on your payments?

If you are like many who started out with a 25-year mortgage, say $150,000 @ 6.0%, your payments are probably at about $960/month plus property taxes. You may also have the same personal debt of approximately $25,000 @ 12 – 18% with payments of about $750/month. So you are obligated to pay about $1710/month on an income that isn’t so reliable. If you were to re-finance now with a $175,000 mortgage over 35-years @ 3.89% (5-year term) your payments are now $760/month. You free up cash of $950/month that you don’t have.

If your income improves you increase your payments &/or make lump sum payments of 15 – 20% (depending upon the lender) to the tune of at least the $950/month you have been saving. You are back to paying off your mortgage in even less than the 25 years you originally signed up for. Even if you don’t make the extra payments you still save the $5,000 on your personal debt. And it’s a win-win situation. The bank is glad to help you with a mortgage that fits your income better. They will have the confidence you can afford it.

The main point I am trying to make is that you have an opportunity to use the value of your home to manage your debt in a way that puts money where it belongs, in your hands.