04 Mar Breaking Your Mortgage Contract
Should You Break Your Current Mortgage Contract to Take Advantage of a Lower Interest Rate?
By: RBC Advisory Services
With rates these days at historical lows, you may be wondering if it is the right time to break your current mortgage and lock into a new term to take advantage of these low interest rates. Remember that if you have a closed mortgage, you will incur what is called a pre-payment charge.
Why do banks charge a penalty to do this?
Lenders incur significant sales, underwriting and funding costs to issue and renew mortgages. Mortgage rates are designed to recoup these costs over the contractual mortgage term.
Most of today’s mortgages are ‘closed’ which, for similar terms, tend to have lower rates than open mortgages. The lower rates are in large part due to the fact that there are prepayment charges which are designed to compensate the lender for the economic costs it incurs when a prepayment amount exceeds the prepayment privileges permitted under the mortgage. These costs include prepayment transaction costs, plus the fact the lender will not receive the full term amount of interest that was designed, in part, to recover the lender’s costs to acquire the mortgage.
In contrast, you can pay off an open mortgage at any time without penalty. However, rates tend to be higher than for closed mortgages with similar terms.
This pre-payment charge comes into play when you want to renegotiate or break your existing mortgage for any reason, including if you wish to acquire a new rate. Your mortgage is a contract with the bank that states you will pay a certain amount each month back to the bank for a certain period of time and you will pay a prepayment charge if you exceed your prepayment privileges.
But the rate is so much lower now, it must be worth it?
Well, that is hard to say. It really does depend on a number of factors – such as your current interest rate, the length of time left on your mortgage term and your mortgage balance. Once you take into consideration the prepayment charge, you may not come out ahead at all.
The other item to keep in mind is no one has a crystal ball on where interest rates will be when your existing term would have expired. This has an impact on whether or not you come out ahead in breaking your current mortgage. If rates are even lower than today, you will be forgoing that lower rate. For example, if you are 3 years into your 5 year term now, and you chose another 5 year term, you could be forgoing an additional 2 years of lower rates that you would have received if you did not break your mortgage today. Of course, no one can predict the future direction of rates.
Everyone’s situation is unique, so to give any rule of thumb is difficult, but generally, it is usually unwise to break your mortgage if you are early in your term (for example only one year into a five year term).
Another recommendation to save you money on your mortgage is take the money that you would have used to pay the pre-payment charge and apply it as a principal payment against your mortgage. This will have a significant result to your overall mortgage costs.