Refinancing

There are many issues you may want to address when you are considering mortgage financing.  One is the subject of refinancing and prepayment penalties:

Mortgage Penalties – How to Beat Them !

With rates being so low, we are receiving a great number of inquiries from our clients who are interested in refinancing their existing mortgage. At 5 year fixed rates as low as 5.27% and 10 years as low as 6.20%, its a great time to review this option. When you do, I urge you to consider the Variable Rate Mortgage option.  The rate is as low as 3%.  Current Prime Rate is at 3.75%.  Yes, interest rate may be going up.  The experts, however, do not expect the Prime Rate to go any higher than 4.75% in the next few years.  So, there is a huge gap between fixed rate mortgages and variable rate ones.

How do mortgage penalties work and what will I be expected to pay?

The mortgage penalty that the lender is entitled to charge you is dependent on a few factors. Firstly, most standard mortgage clauses state that the borrower (mortgagor) must pay the GREATER of three months interest or interest differential (IRD). The IRD part of this clause is fairly vague and some lenders have gotten away with hefty penalties in some cases.

What is an IRD?

Interest Rate Differential is the difference between the rate written on your mortgage and the rate that the bank can lend out the money again in a new mortgage today. Now the lender has some discretion as to what rate they can lend the money out at today, and some will take the discounted rate and some will take the posted rate. The most fair penalties are calculated using the posted rates.

Here is an example of a mortgage IRD calculation. Today’s mortgage balance – $100,000. Rate on mortgage -  7.00%. Term left to maturity: 2 years. 2 year posted rate at the bank today: 5.00%. Penalty calculation: $100,000 x (7.00%-5.00%) x 2 years = $4,000.00. Three months interest on this mortgage at 7.00% would be approximately $1,750.00, so the IRD penalty would be the higher amount charged.

How can I avoid IRD?

It used to be that, if you have a CMHC insured mortgage and it is past the third anniversary date, then the lender can only charge three months interest and not the IRD.  Unfortunately, they removed that clause as of August 16, 1999.  So, it is now entirely up to the individual lender, and it is unlikely that you can avoid the IRD.  However, you can insist on a clear explanation how your lender calculates their IRD.  No two lenders calculate the IRD the same way.

What if my mortgage is more than 5 years old?

Under the Interest Act, an individual (not companies) borrower has the right to prepay all of the outstanding debt with only an additional three months’ interest (in lieu of notice) at any time after 5 years from the initiation of the mortgage. However, you should check to see if you signed away this provision the last time you renewed with your lender

Should I pay the penalty and get a new mortgage?

Looking at the example above, you would be required to pay $1,750.00 up front penalty to break the 7.0% mortgage. However the savings during the first two years of the term would be 7.00% – 5.10% (the new 5-year rate). This would equal a savings over approximately $2,700 during the first two years of the term, PLUS you would receive the added benefit of being locked in for another 3 additional years at a very low rate.  If you look at the best 2-year rate available (3.99%), then the remaining term is the same and the savings would be approximately $3,900.

The penalty you have to pay may actually be less.  In June 2004, a settlement in a class-action lawsuit means that you will have to know what prepayment privileges you are entitled to under your existing mortgage.  Some mortgages will allow you, the borrower, to prepay without penalty anywhere from 10 to 20% of the original mortgage amount every year.  Some lenders have in the past disallow this prepayment privilege when you payout your whole mortgage.  Now the court has ruled that the lender will have to honour the prepayment privilege when you pay it our in full ahead of time.  That means part of the pay-out will not be subject to the penalty.  (You may want to read the article in the June 17, 2004 issue of the Vancouver Sun titled: “June 17 2004 Vancouver Sun Article“.)  Since then, some lenders have added a clause to their mortgage disallowing prepayment benefits, when the mortgage is prepaid in full.

Is there anything else I can do to get out of my high rate mortgage?

Of course, for ease of illustration, the above examples use simplified arithmetic’s and monthly rate assumptions (posted rates are subject to change and, in Canada, are always expressed as semi-annual rates, not monthly).  As mortgage brokers, we have a number of options and lenders who offer a combination of an excellent rate and cash back to pay your penalty (or the other ancillary expenses when you refinance).

Call today to inquire specifically about your needs. When you call, it will be helpful if you already know the following (but not necessary):

• your mortgage balance,
• the maturity date,
• your bank’s calculating as your penalty, and
• the rate your bank offer you if you were to get a new rate with no penalty (this rate is called blend and extend).

If you know the answer to these questions, we can help you analyze the pro and cons of your refinancing issues, and, perhaps,  get a better deal.

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WORDS OF CAUTION

If your existing mortgage was a ‘cash back’ type, you may have to repay a portion or all of the ‘cash’ you received when you prepay.

If you have a high ratio mortgage that is insured by either CMHC or GE Mortgage, your refinanced mortgage cannot have an amortization longer than the remaining amortization of the existing mortgage.  Otherwise, you will lose the mortgage insurance premium you have already paid.

If you need more detailed explanation on this and other related issues, you should get a copy of my free eBook.