Should I Stay or Should I Go Now – Whether or Not to Refinance Your Mortgage and How To Ease The Pain

Covid 19 is the sort of financial tsunami that bowls over and swamps all but the most conservative of financial projections. As we slowly begin to pick ourselves up, dry out our wet clothes and figure what comes next, I am suggesting to many of my homeowner clients with fixed rate mortgages to look at their existing mortgages to see if there are any opportunities to turn at least some of the lemon that is Covid into perhaps a shot glass full of lemonade.

When diving down into the rabbit hole of mortgage refinancing calculations, many surprises may await. Accordingly, I strongly suggest that you arm yourself with the expertise of an experienced mortgage broker like my friend and fellow Moneysaver contributor Russ Morrison that has been around the block at least twice to help you maximize savings and minimize unnecessary bank penalties.  And, after crunching the numbers, if you believe that it does make sense to pay whatever penalties come with paying up your current mortgage, it’s just as important to ensure that your shiny new replacement mortgage provides you with as much flexibility and as many features as possible in order to hopefully help you continue to save for many years to come. Don’t worry – I’ll save that next topic for another article.

How it Works

Trying to understand the ins and outs of whether or not it makes sense to pay down your existing mortgage ahead of schedule is a lot like trying to read a book in a foreign language upside while not wearing your glasses – extremely frustrating, confusing and open to misinterpretation. I’ll talk about the details of how this is calculated in a second, but at the end of the day, these calculations determine whether the savings you’d reap under the new mortgage would be enough if you continued your current payments going forward to pay down the mortgage penalty that you’d be adding to your new mortgage by the time your old mortgage expired. Put another way, if your mortgage balance would be $500,000 after taking advantage of all the prepayment options I’ll discuss later to lower your penalty, with 3 years until renewal, and your monthly payments are $3,500, would a new mortgage for $515,000 (current balance plus an arbitrary $15,000 penalty) and $3,500 in monthly payments leave you with a smaller mortgage balance 3 years from now than would be the case if you just kept paying down your current mortgage? If so, and the hassle factor and any associated costs from making the change aren’t too significant, then you’d want to look at making that change. I highly suggest getting your broker to spell out any additional costs or other downsides in advance so that you’re not surprised later. For example, will there be any legal or appraisal costs and, if so, how much?

Furthermore, if you want access to a new secured home equity line of credit (“HELOC”) from your new lender, how do those rates compare to what you currently have? HELOCs are usually variable and are also based around the bank’s prime lending rate. It is quite possible that in these days of Covid that your new HELOC rate might not be as attractive as your old one. You’ll need to take the extra interest you might be paying on the HELOC in the future into account before making your final decision if you’re planning on using your HELOC extensively going forward.

If your new mortgage is fixed term, then the calculations to determine whether you’re better off refinancing your mortgage are relatively straight forward. If you opt to go variable, however, then these calculations will need to take into account how your variable rate might change over the remaining balance of your current mortgage.  Although in these days of Covid, it is hard to imagine when rates might start to climb again, I still suggest taking this into consideration and crunching the numbers to include at least a rate increase or two at different points of time during the period in question. Taking on a variable mortgage does mean taking on more risk.  Factoring in what things look like if rates do climb, however how unlikely that may currently seem, forces you to see what could happen if life throws us yet another curveball. If you’re still ahead of the game despite these more pessimistic estimates, then you can proceed with more confidence and certainty. If the numbers no longer work, you can either stay with the status quo or, if the savings if rates don’t change are too much to pass up on, then at least you’ll have made an educated decision with a better idea of the downside if things don’t go entirely your way.

Calculating Your Prepayment Penalty

If you pay down a typical fixed rate mortgage ahead of schedule, it’s going to cost you. The penalty is generally whatever is higher – the interest you would have paid on the remaining balance of the mortgage over the next three months, or what they call the “interest rate differential” or (“IRD”), which is allegedly based on the difference between what you would have paid in interest over the remaining term of your existing mortgage vs. what you would have paid in interest over this same period on a fixed term mortgage at current rates for the remaining mortgage term. For example,  if you had 36 months left on your existing mortgage, the IRD would look at the interest you would have paid over those three years under the status quo minus the interest the bank can get now lending out your current mortgage balance to someone else based on their current posted 3-year mortgage rate. In theory, you are compensating the bank for not being able to get as much interest on the money you’re returning to them ahead of schedule when they have to lend it out to someone else now at lower rates.

There is one very important exception to the IRD calculations just discussed. Banks are only allowed to charge an IRD penalty during the first 5 years of your mortgage. After that point, they can only charge three months’ interest. Although longer term mortgages (i.e. like 10 years) are not particularly common (they are generally priced higher than 5-year mortgages for several reasons, one of which is to compensate them for lost IRD payments if the borrowers do cancel beyond the 5 year mark), if you’re the exception to the rule and already beyond the 5 year mark, you should have your mortgage broker on speed dial. You’ll be able to avoid the sticker shock that I’ll be taking about in the ensuing paragraphs if you do refinance.

Calculating a typical IRD penalty sounds pretty straight forward, but all lenders are not created equal and the devil is in the details.  For the naive, if your current 5-year mortgage rate was 3.39% and the posted rate for a three-year fixed rate mortgage today was 2.39% on a remaining mortgage balance of $300,000, you’d expect that the interest rate used to calculate your penalty would be 1%. Not so fast. Your original 3.39% rate was very likely not the “posted rate” advertised to the masses but a discounted rate that is referred to as the “bank rate” or the “discounted rate.” That is also true for the 2.39% rate currently posted – it’s likely that because the bank truly loves you and values your business that they would be willing to go a little lower than the posted rate, but only just for you, of course. As a result, the rate some banks use to calculate the IRD is the difference not between the actual 3.39% 5-year mortgage rate that you are currently paying and that 3-year posted rate of 2.39%, but the posted rate when you took out your mortgage two years ago and that 3 year posted rate. The difference between the posted rate and the bank rate on your original 5-year mortgage may actually be 2% or more higher in some cases! Thus, instead of using 1% (3.39% – 2.39%) to calculate your IRD, some banks might use 3% or more using this example (5.39% – 2.39%). Alternatively, they might get to the same 3% result by subtracting the 2% discount you received 2 years ago from the current 2.39% posted three-rate. Never mind that shorter term mortgages don’t get discounted nearly as much as 5-year fixed mortgages, nor that banks aren’t discounting their rates nearly as much these days in these times of Covid. Put another way, how many lenders out there do you think would be willing to discount their posted 3-year rate of 2.39% by 2% to 0.39%? In the end, there are currently a lot of horror stories regarding some potential prepayment penalties, particularly for those poor souls who aren’t refinancing in order save money under new rates but who might be losing their homes due to the financial crisis or are forced to refinance purely for cash flow reasons.

It’s important to note that banks aren’t the only way to get a mortgage in Canada. In addition to banks, or private mortgages, your choices include monoline lenders (lenders who only do mortgages rather than the whole array of products banks offer) and credit unions.  Generally, banks charge the highest penalties on fixed mortgages, although it really varies from lender. Bottom line: it’s vital to do your research prior to entering into your next mortgage to determine how lenders calculate their IRD penalties, as well as other key considerations like portability (the ability to transfer your old mortgage to your new home) and penalty- free prepayment privileges that can reduce any penalty if you do need to get out of your mortgage at a later date.

In the end, as Russ Morrison, licensed mortgage god, advises, picking the right mortgage is a lot more than just comparing interest rates. That’s why I suggest working with a mortgage broker rather than going it on your own. It’s free, you get to shop the entire mortgage market and you also get lenders’ best rates up front rather than only after you’ve found a lower rate elsewhere.  Perhaps most importantly, however, a good broker will walk you through the other considerations I’ve just discussed so the mortgage you pick fits you like a glove and you know how to optimize its features.

If it still makes sense to prepay your mortgage, there are a few things that might minimize the pain:

• Be strategic when picking the time to pay down your mortgage. Get your broker to calculate both the savings and penalty happen to be if you pay down at different points in time. One of the big things to keep in mind, however, is that you won’t know for sure what the posted rate for the period closest to your remaining mortgage term will be in advance, nor the rate that you’d be able to get on the new mortgage that you will actually take on. If you try to get too cute, you may not be able to get the same mortgage rate offered today, which could more than offset any reduction to your mortgage penalty you might get by waiting. As well, using our previous example, if you wait until there are only 2 years left in your current mortgage, the IRD would look at the 2-year posted rate rather than the 3-year one. It could well be that the 2-year rate is lower than the 3-year posted rate, which means that, although the calculations would only look at 2 rather than 3 years of lost interest for the bank, the rate used to calculate that penalty may actually be higher: for reducing the IRD, you usually want the posted rate offered for the remaining term of your current mortgage to be high, not low so that the difference between the two rates (and thus, the rate used to calculate your penalty), is as low as possible.

• Prepay the pain away.  When calculating the best time to pay down, it’s vital to remember that the penalty is only applied against the outstanding balance at the time of paydown.  Thus, the less you then owe, the smaller the penalty you’ll incur when repaying the bank’s dough. This will occur naturally over the lifespan of any mortgage, although if you’re still 25 to 30 years before it’s scheduled to be paid down completely, each payment at this stage is likely mostly interest anyway. There are steps you can take, however, to hammer down your mortgage balance before you pay it out and, as a result, significantly reduce any mortgage penalty. Most mortgages allow you to pay a set percentage of the original balance loan (a range of 10 to 20% is pretty common) each year in one or more lump sum payments. You may also be allowed to increase your regular payments by that same percentage, too, often without this affecting how much you’re able to prepay in lump sum payments. I’ll dive into the ins and outs of prepayment rules in a separate article but here are the basic things to keep in mind when looking at these options:

• The early bird gets the worm. The earlier you start prepaying, the smaller your mortgage balance when it’s time to calculate the penalty.  Each prepayment means that every regular payment you make thereafter will be directing more money towards the mortgage balance rather than in interest payments. Just like when looking at investment returns over the long term, the magic of compounding also casts its financial spell when trying to reduce your mortgage balance by making extra payments as soon as possible.

• Read the fine print and use it against them. Different lenders offer different prepayment percentages and features. Some allow you to make as many lump sum payments each year over a small minimum payment amount as your heart desires, while others aren’t as generous. Others may even restrict when you make your annual prepayments to a set date, such as each year’s mortgage anniversary! Since you’re stuck with these rules and limitations, it’s essential know the hand you’ve been dealt so you can employ these rules to your best advantage. For example, are the prepayment periods based on your mortgage anniversary or the calendar year? If you’re planning to pay down your mortgage, you could save you a lot of penalty dollars if you diarize the earliest date you can make your next lump sum prepayment and time your mortgage paydown for after you’ve done just that. If you have a 20% yearly prepayment privilege, getting to make an extra 20% prepayment reduces your mortgage penalty by that same 20%!

• Let your HELOC lend a hand. Although taking advantage of the prepayment privileges propounded in the preview paragraph may sound promising on paper, it might be another thing entirely coming up with the money to make this happen in the real world. That’s where your existing HELOC comes in.  If you use your existing HELOC or even arrange a new one in anticipation of paying out your mortgage early to fund lump sum prepayments or also free up the cash to also increase your regular payments as well, this can take a huge bite out of that future mortgage prepayment penalty. And, when it’s time to take out that cheaper, lower rate mortgage, you can borrow enough to pay down the balance of the HELOC. Even better, since the prime lending rate has fallen so fast so soon, the interest you’re paying on it in the meantime may actually be significantly lower than the rate that you’re paying on your current fixed rate mortgage anyway.  Not only will you be reducing the penalty you’ll pay the bank down the road – you’re doubling down your savings by reducing the rate of interest you’ll be paying along the way as well!

•  Consider using your TFSAs to turn the tide. If you’ve got a lot of money already tucked away in your TFSAs and you’re still struggling to come up with your prepayment, consider dipping into your TFSAs to come up with a bit more cash.  You can always borrow back the money to fill up your TFSAs as part of your new mortgage, although you will have to wait until the next January before you can replace the money you’ve withdrawn. This option works best for investors who don’t expect a lot of growth or income from their TFSAs between now and then, as the opportunity cost for reducing the prepayment penalty using your TFSA loot is the tax-free income and growth you would have received had you stayed invested. If you’re one of those people who have calendar prepayment privileges and want to make that final penalty-free prepayment in January before refinancing your mortgage, consider pulling your TFSA money out in late December if you want to minimize potential lost investment growth. Your new mortgage can include enough money to restock your TFSAs and you can start earning tax-free TFSA dollars once again with minimal opportunity cost. Just don’t try to claim a tax deduction on the money used for TFSA purposes, as that’s not allowed.

• Cash in your cash accounts. Another potentially useful way to prepay that mortgage is to sell existing non-registered investments to raise the cash. There will be a tax bill to pay on any capital gains, so you’ll need to take this into account before making this decision. If you were going to be selling some of the investments anyway within the next couple years and are worried about having to pay more tax on capital gains in the future like I am, this might be something you could consider doing anyway. Want to stay invested? Perhaps you can use your HELOC to buy back those investments. Not only will this reduce your eventual prepayment penalty and perhaps even lower your combined interest rate if your HELOC interest is lower than your fixed rate mortgage, you can now write off the interest on the money you’ve used to repurchase those investments! If selling investments at a loss, however, be sure not to repurchase the exact same ones or wait for at least 30 days after selling to do so or you won’t be able to claim that loss for tax purposes. When eventually getting your new mortgage, you’ll likely need to pay down the existing HELOC, which might mean having to sell your investments again, but you can take out a new HELOC at that point with whoever is issuing your new mortgage or even look at carving out a separate mortgage just for investment purposes if that gives you access to a lower interest rate.Either way, try to keep the investment loan portion of your mortgage or any HELOC as a separate mortgage or portion of any HELOC for tax purposes. Not only will this make your accountant far happier, it will also likely save you a bunch of tax dollars going forward. If the debts are kept separate, you can arrange your finances so that you pay as little as possible towards your deductible debts and direct more towards your non-deductible ones. As a result, more of your debt and more of your interest will be tax-deductible, which can result in significant tax savings.

Final Considerations

When refinancing your mortgage, there may also be some opportunities to reduce your current expenses if times are tight. Although the break-even calculations assume that you’d continue your normal payments under the new mortgage and keep your amortization period (i.e. the number of years before your home is completely mortgage-free) the same, you don’t have to do either of these things.  Under your new lower rate mortgage, your minimum regular payments will probably be lower despite adding the interest penalty to the balance. If your focus at this point is on keeping your monthly costs lower, you could likely reduce those payments slightly and still have the penalty paid down by the time your current mortgage would have expired. Or, if cashflow is particularly tight, you might decide to decrease your payments and increase your amortization period which could significantly reduce your regular payment costs to make ends meet until your finances improve. At that time, when funds permit, you could look at increasing your regular payments under the prepayment privileges provided under your new mortgage in order to get things back on track. For some of us, the decision to pay down our current mortgage may even be based purely on reducing our regular costs even if the size of the penalty doesn’t otherwise justify making the change. If you’re in that boat, you’ll just have to make sure that you still qualify for a mortgage or to see if you have any relatives willing to act as guarantors.

Conclusion

Although 2020 has caused many financial problems for far too many Canadians, there may at least be a few ways of easing the sting and helping us get our houses back in order. For some of us, paying down our mortgage early might be one such opportunity.