Breaking up isn’t always hard to do

Newspapers have had their fill of economic doom and gloom recently with reports of massive job layoffs, falling profits and rising bankruptcies. But there’s at least one headline that has Canadian homeowners taking notice: mortgage rates are hitting record lows, with lenders offering fixed five-year rates for about four per cent.

Lower rates and the promise of freer cash flows are prompting a growing number of Canadians to consider breaking their current mortgages. In fact, recent figures from CanEquity report that 17.3 per cent of mortgage application inquiries are related to refinancing. And according to a recent CIBC World Markets report, this wave of refinancing is expected to last for at least six more months.

“Given the dramatic drop in rates across the curve, I think it makes sense for every Canadian with a mortgage to spend an hour or two analyzing whether their mortgage is worth negotiating,” says Moshe Milevsky, an associate professor of finance at York University’s Schulich School of Business in Toronto. “At best, you save a few dollars. At worst, the answer is no.”

And experts agree that if you’ve ever considered refinancing, the time to do so is now. For, as good as today’s rates are, they won’t always be this low.

“Within the next year is probably a good time if you’re thinking about refinancing because you’re going to get in at the bottom rate,” says Joan Dal Bianco, vice-president of real estate and secured lending at TD Canada Trust. “A couple of percentage points off your mortgage payment can be fairly significant on a monthly cash flow basis.”

But these savings come at a cost.

What you need to know
While most people know that there are penalties associated with breaking a mortgage, many are still surprised to learn how steep those fees can actually be, says Sean Binkley, a mortgage agent with Mortgage Intelligence in Kingston, Ont. 

When you pay out a mortgage before its term, you’ll be charged the greater of either a three-month interest penalty or an interest rate differential, or IRD, which essentially compensates the bank for the lost interest on the higher-rate mortgage.

“If the current rates are four per cent and you’re paying out a 5.9 per cent mortgage, then you’re going to be charged that 1.9 percent difference up to the end of your remaining term,” says Binkley. “On a $200,000 mortgage, if you’ve got 2.5 years left on it, that’s going to be almost $10,000. That’s not pocket change.”

On top of that, you’ll need to pay legal and appraisal fees, which can easily add an additional $1,000 to your costs.

The good news is that fees can be tacked on to the new mortgage and amortized over the remaining maturity period. Or, if you have access to cash or, more likely, a line of credit, the fee can be paid outright for what is known as a free switch, saving you legal and appraisal costs, as well as interest.

But Binkley cautions against tapping into a line of credit or other form of debt. “It may work for some people if they think they can pay that line of credit quickly, but not if it becomes another never, never payment plan. It also depends on the interest rate. There are some lines that are at 2.5 per cent and others at 6.5 per cent — to borrow at 6.5 per cent to get a 3.99 per cent mortgage rate may not make sense,” he says.

How to decide
While the concept behind whether to refinance is relatively simple — you compare the cost of breaking a mortgage to what you will save in future interest payments — there are a number of other factors that go into the calculation. You need to consider your mortgage balance, current rate, new rate, the remaining term, remaining amortization and the pay-out penalties as of today (as mortgage rates drop, IRD penalties increase).

A good place to start is online with the Mortgage Savings Calculator, created by Milevsky and featured on the Canada’s Office of Consumer Affairs website.

But while online calculators are useful, mortgage refinancings are complicated, so it’s best to contact your lender or broker to discuss your options. Make sure you get supporting documents on the lender’s calculations and amortization schedules, suggests Binkley.

When not to refinance
Even if times are tight, if you’re thinking of selling your home within the next six months to a year, it may be best to leave your current mortgage alone unless the lender will transfer your mortgage to the new property.

Or, if you’re lucky enough to be carrying a variable-rate mortgage at the old discounted rate of prime minus as much as 90 basis points, or 1.6 per cent — don’t touch it. Your savings can’t get much better than that.

“You may want to consider locking in with your own institution, but you don’t want to break that mortgage,” says Binkley. “In my opinion, you should just leave it,” or start paying extra on it, he says.

Other options
If refinancing doesn’t make financial sense, there are other options to help manage your monthly payments such as blending and extending your mortgage (blending the new lower rate with the old higher rate,) lengthening your amortization period, or if times are really tough, even skipping payments (the payments get added back into the mortgage).

The key is to be upfront with your lender from the start and don’t try to withhold information.

“We’re proactively trying to get customers to tell us in advance of getting into trouble so we can look at refinancing options,” says Dal Bianco. “We’re looking for opportunities to keep people in their homes and make it through tough times. It doesn’t do anybody any good if we have people out of their homes.”

“Don’t ignore the opportunity,” says Milevsky. “When times are tough, every dollar counts much more than it has in the past.”