If you have received new mortgage financing or renewed your mortgage over the past few years, you likely benefited from an interest rate that was among the lowest rates offered in recent history. Some may recall the high cost of borrowing in the early 1980s where the average residential mortgage lending rate reached as high as 21.46% in September 1981,¹ with subsequent costs of borrowing trending downward over the next 40 years. Fast forward to 2021 when we're seeing some of the lowest rates ever. But despite the low rate you may have received in the past five years, does it make sense to break your existing term and renew at an even lower rate? Let’s explore.

A home is one of the largest expenditures many of us will make, and decisions around debt management can significantly impact long-term wealth. To illustrate a 1% difference in mortgage rates, consider the following scenarios for the same mortgage amount:

The first question to ask is will renewing your mortgage early save you money? In order to answer that question, you will need to determine both the savings and costs of doing so. In the example below, we’ll review the interest cost differences but it’s also important to be aware of the other costs associated with renewing early. Each of these must also be taken into account when assessing the cost or benefit of breaking your existing term and renewing at a lower rate.

Prepayment penalties

If you have a closed² mortgage term, your lender might charge a fee if you: pay in excess of what’s allowed under the terms of your mortgage; break your mortgage contract; transfer your mortgage to another lender before the end of the term; and/or, pay the entire mortgage in full before the end of term. The penalty will depend on factors such as the amount you are paying, the time remaining on your current mortgage term, and interest rates. 

Typically, the prepayment penalty will be calculated as the greater of either three months of interest on what you still owe, or the interest rate differential (IRD). If the interest rate on your mortgage is higher than the current interest rate, and you signed your current mortgage contract less than five years ago, it’s likely the IRD calculation will apply. Some lenders might also charge fees or “breakage costs” in addition to prepayment penalties. 

Cash-back incentive

Some mortgage lenders will offer incentives to entice borrowers. A cash-back incentive is one where the borrower receives “cash back” after the mortgage is funded based on a pre-stated amount or formula. In many cases, this added perk could be beneficial to a borrower, providing thousands of dollars that could help assist in cash flow expenses associated with a home purchase such as moving, legal and other costs. 

As with all major financial decisions, it’s important to consider your overall financial needs along with your intended goals. Cash-back incentives can be a great option in the right circumstance. Although, if you break the mortgage contract earlier than the term specified, you could be required to repay a portion, or all, of any incentives received. 

Tip: Your mortgage document should indicate exactly how your lender will calculate your prepayment penalty. You can also check with your lender for an interim estimate of the penalty. Most lenders should be able to provide information such as prepayment privileges, penalties, how they calculate your prepayment penalty, and what factors they use to determine the penalty. 

Other fees

Sundry fees may also be applicable such as mortgage discharge fees to remove a charge on your current mortgage, and fees to register a new one. These could be significant, and it is important to determine all relevant costs in order to properly assess what your overall savings could be, if any.

With your penalty costs confirmed, you can compare these with the savings from staying in your current mortgage, and the savings from breaking the mortgage to enter a new term with a lower rate. Let’s review a sample analysis in the following case study.

By focusing on the remaining three-year term, we can compare the costs of the existing mortgage with those of the alternatives for the same period. The results below indicate similar interest savings over the short three-year term, but there are several other factors to consider as outlined.

Tip: A financial planner and/or mortgage advisor should be able to help you determine these calculations. There are also a number of online tools available that can help you assess various mortgage scenarios. 

Here we can see that, when considering the penalty to break their existing term, the net financial results reveal there would be no benefit to incurring a penalty in order to negotiate a new mortgage. In addition, interest savings are not immediate when the time value of money is considered. That is, the interest savings occur over a period of three years, whereas the penalty cost is an amount to be paid today. 

In a situation where Kelsey and Pat are facing cash flow difficulties, it might still be beneficial to incur a slight cost in order to manage their monthly budget. However, they would need to identify how they would pay for the penalty, either by using existing savings, or by including the penalty as part of the new mortgage financing. If the latter, then costs would be even greater as they would then be financing an additional $8,500.

Financial management is a formal part of the financial planning framework. Your financial plan should address your personal goals, needs and priorities. See our article on financial planning and your mortgage. Good planning should also consider other relevant financial planning areas, and the relationships between them.