Early Renewing Your Mortgage Term

With the recent decline in rates for fixed term mortgages, more and more home owners are looking to see whether it's worthwhile breaking their existing mortgage term. The upside for many home owners, depending upon what their goals are is that they can either lower their current mortgage payment for better cash flow or they can continue on with their existing payment and reduce their amortization. The prospect of saving thousands of dollars in interest is extremely appealing but there are a few factors that warrant careful consideration. Most borrowers understand that they will trigger an early prepayment penalty to get out of their current term. However, you should be aware that financial institutions calculate the penalty two ways and use the higher of the two amounts as the penalty. Most people are very familiar with the three month interest penalty which is merely the interest portion of your regular mortgage payment multiplied by three months. The other formula that the financial institutions use to calculate your penalty is the the interest rate differential (IRD). The IRD is the difference between the existing rate and the rate for the term remaining, multiplied by the principal outstanding and the balance of the term.

Example.

• $100,000 mortgage at 6.50% with 24 months remaining.
• Current 2 year rate is 4.0%.
• Differential is 2.5% per annum.
• IRD is $100,000 * 2 years * 2.5% p.a. = $5,000

The IRD is now coming into play for many fixed term mortgages because of how much the rates have dropped. I am finding that borrowers are extremely surprised by just how much their penalty is to break their existing mortgage term. Should interest rates continue to go even lower then that will translate into larger penalties. I still feel strongly that home owners should evaluate their current mortgage term and have a Mortgage Specialist calculate the benefits of early renewal. Many borrowers will still realize substantial savings over the course of the term by paying the penalty and locking in to the lower rates. The good news for those home owners who are in a variable mortgage is that the penalty is strictly three months interest.

Some financial institutions will allow you to include the penalty in your mortgage so that you are not required to pay it from your own resources. Any interest savings would then need to recalculated with the penalty amount added in to your outstanding mortgage balance. Other financial institutions will allow you to take cash back when you refinance in order to offset the penalty in part or in whole. Be aware though that while cash back sounds appealing, the interest rate will be increased accordingly by the amount of cash back you decide to take. The bottom line is that financial institutions are not going to offer these options if they are putting themselves in a worse off position. In fact, most of these options puts the financial institution in a better position because they will likely end up earning more interest from you in the long run.

One quick tip that can be a very effective in reducing your penalty is to pay down your annual allowable lump sum payment. Some financial institutions will automatically take it off when calculating the penalty while others will not. It's definitely worth asking your financial institution how they calculate the penalty prior to breaking the term. You should also be aware that some financial institutions only allow you to make the lump sum payment once a year(on the anniversary date) while others allow you to make one lump sum payment at any point during the year.

Another consideration that home owners should make when deciding to refinance is how it could possibly affect their insurance coverage. This is specifically for those borrowers who have taken the creditor insurance which went with the mortgage, in order to protect their families in the event of death, disability or critical illness. I strongly recommend that you find out what the implications are to your insurance coverage. Most creditor insurance premiums are based on the age of the borrower at the time of the initial application and remain in effect for the life of that mortgage. Not only could you potentially lose a very low insurance premium but you may have become uninsurable in the meantime and unable to qualify for any subsequent insurance.

Some of the more minor costs associated with early renewing but still applicable are the following. Legal costs($500) if switching to another financial institution or increasing the amount of the mortgage with your current provider. Appraisal costs($300) which may or may not be picked up by the financial insitution. Title Insurance($250+) if required by the lender. Transfer out fee($80-$200) charged by your current financial institution.

Variable versus Fixed Rate Mortgages

One of the most frequent questions I'm being asked is whether it makes sense to go with a variable rate mortgage over a fixed rate mortgage. Unfortunately there is no easy answer to this question because statistically speaking those who have chosen to go with the variable rate mortgage have been the beneficiaries more than 80% of the time. As we saw though in the latter half of 2007, the variable rate can move quickly and for those who were looking to lock-in to a fixed term, the rates had already gone up considerably. One of the key determinants I suggest in determining which one is best for my clients is their capacity to accept the interest rate risk and be able to afford a higher payment in the event that the rates go up. Fixed rate mortgages carry neither of these risks as the borrower knows their interest rate and their payment for the length of the term. Another factor for consideration is that clients must be more dilligent in monitoring rates both on the variable side and the fixed.
Economic factors will determine how long rates continue to remain at record lows as central banks around the world try to stimulate growth. There is no evidence to date that the global recession is turning around or even nearing a bottom. This bodes well for those who have chosen the variable rate mortgage as there seems little risk in the forseeable future that the Bank of Canada will start to increase rates any time soon. The caveat to this statement however is that given the flood of liquidity the Bank of Canada is pumping into the financial system, there will come a point at which the economy will gain traction and begin to turn around. Once this point is reached, the massive amount of money that the Bank of Canada has injected into the economy runs a serious risk of creating severe inflationary pressure. The only option for the Bank of Canada is to raise interest rates quickly and try to suck the excess liquidity out of the system. That is why borrowers who have chosen a variable rate mortgage will need to be extra dilligent in looking for signs of an economic recovery and be ready to act quickly to convert their mortgage to a fixed rate term.