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What It Costs to Break a Mortgage

One day you may find yourself in a beautiful house, with abeautiful wife, and ask yourself “How did I get here – with this interest rate?”

Or maybe you aren’t living in a Talking Heads reference and are just moving for a new job. In either case, you would have to break your mortgage to take advantage of lower interest rates or a new position.

 

Unfortunately it’s not free to break your mortgage contract, unless you opted for an open term mortgage. In most fixed and variable mortgages, you’ll have to pay a penalty when you break a mortgage in the middle of your term – and what it really costs to break a mortgage may surprise you!

Reasons to break your mortgage

Many Canadians don’t expect to break their mortgage, which is why the five-year fixed term is the most popular mortgage term in Canada, accounting for 68% of all mortgages.

But as it turns out, life has a way of getting in the way of your perfectly laid plans. The average length we keep our mortgage terms for is just 3.8 years, instead of the full 5.

Moving

One of the most common reasons to break your mortgage early is because you need to move. It’s sometimes possible to port your mortgage to your new property, but you may have to break it instead.

You may be moving across the city or country to live closer to work, or you may need to get a bigger place as your family grows. There are plenty of reasons you may decide to move that don’t line up perfectly with your mortgage term.

It’s technically cheaper to wait until your term expires to sell your house, but the lost time may end up costing more in the end. If your reason for moving isn’t urgent, then you can save a couple thousand dollars by waiting.

Interest Rates Are Going Down

This isn’t likely today, as the Bank of Canada just raised the overnight interest rate to 1.75% (meaning banks raised their mortgage rates, too). But if you look at the past decade, rates were steadily dropping for several years.

If you got a mortgage in 2010, for example, you might have had an interest rate of 4.11% for a five-year fixed mortgage. Just 3 years later interest rates had dropped to 2.69% for that same mortgage. You might understandably have wondered if it would have been worth it to switch.

To put it in perspective, a $300,000 mortgage at 4.11% amortized over 25 years would cost $1,597 every month. That same mortgage at 2.69% would cost just $1,373, $224 less per month. That would save nearly $2,700 per year, and over $8,000 over the remaining mortgage term.

That sounds great until you realize that it can cost more than $8,000 to break your mortgage early, depending on the type of mortgage you have.

 

Cost to break your mortgage

There are two types of penalties for paying off your mortgage early – three months’ interest or something called the interest rate differential.

Three months’ interest is as simple as it sounds. Your lender calculates just the interest cost of carrying your mortgage for three months from the date you decide to leave and charges you that.

The interest rate differential (IRD) is a bit more complicated and nearly always more expensive. If the IRD penalty is less than a 3 months’ interest penalty, your lender will charge you 3 months’ interest.

The way IRD works is by comparing the rate on your current mortgage with the rate on a new mortgage. The new mortgage’s term length is equal to the amount of time remaining on your mortgage, rounded to the nearest year. So if you have 38 months remaining on your mortgage, your lender will look at the interest rates of 3-year terms.

A 5-year fixed mortgage had an interest rate of 4.11% in 2010, so let’s think about what would happen if you broke it in 2 years. After 2 years in your mortgage term, you would have 3 years remaining, and the lowest 3-year mortgage in 2012 was 2.69%.

We now have two interest rates – 4.11% and 2.69%. Both of these numbers will be used to calculate the interest rate differential, which is a ratio based on your old and new interest rates.

The differential is the difference between the two rates – so subtract your new rate from your old one. In this case, that would be

 

4.11% - 2.69% = 1.42%

 

That number is then converted to a monthly rate by dividing it by 12.

 

1.42% ÷ 12 = 0.1183%

 

That number is the interest rate differential.

The next step is to multiply the differential by the number of months remaining in your term. In our example we have three years left, so that means there’s 36 months.

 

0.1183% × 36 = 4.26%

 

Finally, we multiply this number by the remaining mortgage balance to determine the penalty.

 

4.26% × $300,000 = $12,780

 

As you can see, this is quite a bit higher than a variable mortgage penalty.

In cases where the new mortgage rate is higher than the old one, you’ll only have to pay 3 months’ interest even if your mortgage is fixed.

 

Avoiding Pre-Payment Penalties

The easiest way to avoid pre-payment penalties is to get an open mortgage, but that’s not necessarily the best. Open mortgages are more expensive than closed mortgages, and unless you’re really sure you will pay off the mortgage soon then it won’t be worth it.

The best open mortgage rate in Canada right now is 4.75% - that’s 1.85% higher than the best mortgage rate in Canada. On a $300,000 mortgage you would end up paying $539 more per month with the open rate. That’s $6,468 per year!

In order for the open mortgage to be cheaper than a variable mortgage, you’d have to sell the house 3 months or sooner after buying it. A good option for house flippers, but not for the average person.

If you’re refinancing to take equity out of your property, then you may be able to get your penalties reduced by applying for your refinance at the same bank you’re already with.

 

Should I break my mortgage to refinance or get a 2nd mortgage?

Both a second mortgage and a cash out refinance allow you to take equity out of your home. Both have their benefits and drawbacks, though.

Refinance

2nd Mortgage

Lower interest rate

Higher interest rate

One creditor, one payment

Two mortgages to keep track of

No origination fees

Origination fees

Can be used to extend amortization

Cannot extend amortization

Have to break mortgage or wait until term ends

Can be added at any time

Reduces equity in your home

 

If you’re considering getting a home equity loan or a refinance, be sure you know which one is better for you. Getting a 2nd mortgage is usually a cheaper short-term option, and refinancing wins as a long-term option, but it varies from person to person.

 


Chris Chris 01/26/2019
Canadian personal finance buff and all-around writing enthusiast, Chris loves breaking down complicated money ideas to show that they're really not so complex. 
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