Refinancing is attractive, penalties aren’t

After the Bank of Canada’s overnight rate dropped to just 25 basis points, most of the country’s major lenders responded by reducing their prime lending rates. And with current rates at uncharted lows, it may be worth taking a penalty to refinance at a lower rate.

With rates having fallen so far, so fast, the rate differential between January’s bargain rate and the new rates is substantial. Hefty savings can be realized by lowering to a new rate, whether fixed or variable. For Canadians nearing the end of their mortgage terms, this is a great time to shop around.

Homeowners who still have time left on their mortgage will have to assess their situation individually to decide whether they would come out on top over the long term by refinancing into a new mortgage and taking the penalty charges on their current one.

“If you’re in a 5% rate mortgage, you can go down to 3.69% or 3.5% depending on what happens over the next little while. By doing this you can be saving tens of thousands of dollars over the life of the mortgage. Over 25 years it could be hundreds of thousands. It really is a huge amount of savings, ” says Jim Rawson, a Toronto-based regional manager of mortgage brokerage Invis.

“Refinancing is a question of whether pre-payment is going to be beneficial or not, ” he says. “Canadians locked into the really low rate mortgages, known as the no-frills mortgages have some pretty big pre-payment penalties attached to them. ”

Rawson says no-frill mortgages can have penalties that charge the interest rate differential left on the mortgage between the rate being paid and the bond market rather than prime.

“Those penalties can be astronomical, ” he says.

Know the penalties

The complexity and variation of mortgage penalties probably necessitates hiring a real estate lawyer if a client is considering breaking an existing mortgage, says Ray Leclair, a lawyer himself, and vice-president of TitlePLUS, a subsidiary of LawPRO that offers title insurance policies.

“The concern you have to be careful about is you are in a [legal] contract. It’s a mortgage but it’s still a contract. If it’s a closed mortgage, it cannot be paid out before the expiry date without penalty, ” he says. “Whenever anybody thinks about doing this, they should contact their real estate lawyer who did their mortgage transaction, or otherwise review documents before they get into a bad situation. Then they’ll have to have a new lawyer attend to register the new mortgage. “

Leclair says the common penalty for most closed mortgage is usually the interest rate differential left on the life of the mortgage or three months of interest payments. With a historically high spread between new rates and the rates a homeowner may be carrying, most institutions will likely opt to charge the interest rate differential—which could be substantial.

Once homeowners have the penalty information they have to sit down and do calculations to determine which is the better deal over the long term: Short-term penalty or long-term savings over the life of the mortgage by paying a lower rate.

A huge factor in this decision will be if the mortgage is relatively new. Having a lower rate at the beginning of the mortgage will allow a homeowner to pay off a larger proportion of the principal negating some of the blow of long-term interest compounding.

Factor in all costs

Costs, other than the penalty, may be factored into breaking a mortgage. Clients who tack a secured line of credit onto their mortgage may be opening a whole new can of worms if they break the contract. That mortgage and the equity in their home may be securing multiple lines of credit, Leclair warns. Breaking the mortgage could put those lines of credit in jeopardy.

There are also administrative costs, Leclair says.

“Sometimes banks will charge up to $200 for the privilege of going through their records and making sure the homeowner has paid off their mortgage and signing-off on it, ” he says.

Fixed or variable?

Whether to refinance at a fixed or variable rate is a big question. According to the most recent statistics from the Canadian Association of Accredited Mortgage Professionals, 68% of Canadians have fixed rates.

Rawson says many of the refinancing clients he’s seeing in variable rate mortgages are asking whether they should look at getting a fixed rate, since it’s hard to imagine rates getting lower. Rawson says the lowest fixed rate right now is about 3.69%.

“Given what the Bank of Canada was saying yesterday, these rates are probably here for a while. My advice to most variable rate clients is if you are doing prime minus 80 or prime minus 90 mortgages, you leave them where they are. The most current variables are about prime plus 75. You’re getting savings with a variable rate mortgage,” he says. “Fixed rates are all about risk tolerance. But if you’re a client who stays up nights and worries about what’s going on with prime you can get a fixed mortgage at 3.69%.”