When Does It Make Sense to Break Your Mortgage?
Breaking your mortgage happens when you change your mortgage contract terms, terminate your mortgage contract or want to pay down more of your mortgage than you’re allowed to. You could want to do this because you want to refinance to a lower interest rate (e.g. when rates go down during a recession), you need a new mortgage to buy a home, or you want to pay off your mortgage early. Whatever the reason, you may have to pay a prepayment penalty set by your lender in your mortgage contract plus any costs for setting up a new mortgage if you need one. If you have a choice about whether to break your mortgage, it only makes sense to do so if you save more money in the long term than you’ll have to pay in penalties and fees.
What are the different types of mortgages?
There are two pairs of mortgage terms that you need to be familiar with when you look at mortgages – open– and closed-term and fixed and variable-rate.
Open- and closed-term mortgages
An open mortgage lets you pay off the entire mortgage amount whenever you want to. You still have to make regular principal and interest payments, but you can make additional payments to the principal when you want to without a prepayment penalty. Any of the issues of breaking a mortgage don’t apply to an open mortgage. However, interest rates with open mortgages are generally higher than closed-term mortgages. Most people don’t plan on paying off their entire mortgages soon, so closed-term mortgages are more popular due to their lower rates.
A closed-term mortgage is one that you take out for a specified term, usually 5 years in Canada and 30 years in the US. In addition to your regular principal plus interest payment, most closed mortgages let you pay off an additional lump sum (e.g. 10% to 20% of the principal) once a year. If you want to pay off more than that, you’ll have to pay a prepayment penalty[1,2].
Fixed- and Variable-rate mortgages
In a fixed-rate mortgage, the interest rate is set for the whole term, regardless of the lender’s Prime rates (which have a strong correlation with the Bank of Canada benchmark rate in Canada or Federal funds rate in the US). To change your mortgage rate, you have to renegotiate your mortgage. Your regular monthly mortgage payment stays the same for the length of the mortgage term.
With a variable rate mortgage, the mortgage rate is usually set to the lender’s Prime rate plus or minus a certain amount. If the Prime rate changes, which typically happens if the central bank’s benchmark rate changes, your mortgage rate will change accordingly [1,2].
What does breaking my mortgage mean?
Breaking your mortgage is considered the same as ending your mortgage before its term is up. It only applies to closed-term mortgages.
You’re allowed to pay off a certain amount of the mortgage principal each year through the regular payments and the annual lump sum payment. If you want to pay off more of the mortgage or to end it entirely, you need to break your mortgage.
Reasons for breaking your mortgage
Here are some potential reasons for breaking your mortgage [3,4,5]:
- You have three years left of a five-year, fixed-term mortgage. You’re paying 4.6% interest and your bank is now offering 3.2% for a five-year, fixed-term mortgage. You think the rate might rise in a few years, and you want a new mortgage at the lower interest rate.
- Your mortgage is a variable-rate mortgage and you think that the interest rate is now as low as it’s ever going to get. You want a new mortgage that’s locked in at the current low rate.
- You’ve come into some money and want to put $150,000 towards your mortgage principal, but can’t because it’s much higher than what’s allowed in your mortgage contract.
- You’ve racked up some significant credit card debt and you’re paying interest at over 20%. Your financial advisor has strongly recommended that you take some equity out of your property and consolidate your credit card debt into your mortgage.
- You’re struggling to meet your regular mortgage payments and want to reduce them by amortizing your mortgage over a longer period.
How much will it cost to break my mortgage?
There are many costs and fees that could go into breaking your mortgage, especially the prepayment penalty. When deciding whether or not to break your mortgage, you need to save more in the long term than the penalties and fees cost you now. Just a reminder, if you have an open mortgage, this doesn’t apply to you – you can pay off all or some of your mortgage without penalty whenever you want.
The prepayment penalty
When you break your mortgage, you have to pay a prepayment penalty. This penalty varies slightly from lender to lender, but we have listed the general rules. Read your mortgage contract’s fine print and contact an experienced mortgage broker or your lender for more details.
For variable-rate mortgages, the prepayment penalty is usually three month’s interest on the amount you want to repay.
For fixed-rate mortgages, it’s more complicated and involves the Interest Rate Differential (IRD). The IRD is the difference between the amount you owe on the remaining mortgage amount at your contract’s interest rate and the amount you would owe on that mortgage amount at the current posted interest rate, which is typically much higher than the rate you can borrow at from mortgage lenders. Your prepayment penalty is the greater of the IRD for your mortgage or three months’ interest costs at your current mortgage rate
As we said, it’s a bit complicated, so be sure to find an expert and ask their advice [1,6,7,8].
Getting a break with the prepayment penalty
If you’re towards the end of your mortgage, your financial institution may offer a blend-and-renew option. The interest rate of the old mortgage is blended with the interest rate of the new one, and you may escape the prepayment penalty .
If you’re taking out another mortgage, then you must include the administrative fees for doing so in your calculations, as well as an appraisal fee on your new property. These fees may not apply or may be waived if you stay with the same lender. There may be administrative fees associated with closing your old mortgage as well. Make sure to ask about the fees for removing the charge on your current mortgage and for any other administrative charges that your mortgage contract says that you’re responsible for paying .
How will the stress test affect you?
Breaking your mortgage and taking out another one at a lower rate may seem like a great idea, but don’t forget about the mortgage stress test. Whenever you apply for a mortgage with a new lender, they run your financial details through the stress test in order to ensure that you will be able to make your mortgage payments. The interest rate they will use is the higher of your mortgage rate plus 2% and the applicable BOC benchmark rate (5.19% as of March 2020). If you can’t afford the new mortgage, you may fail the stress test and not qualify for the new mortgage.
However, you don’t have to take the stress test if you stay with your current financial institution. It may be worth taking a higher rate with them if you think that the test may be a problem for you.
Does it make sense to break your mortgage?
We’ve said that deciding whether to break your mortgage comes down to the savings and costs. You should save more than the penalty and fees will cost you. But remember that’s over the long term. If you have a variable-rate mortgage and you think that interest rates are going to rise, then it may be worth locking into a fixed-term mortgage, even if you won’t save any money at current interest rates. Once interest rates rise, you’ll save on interest compared to if you had stuck with the variable rate.
If you’re struggling to make your mortgage payments, renegotiating your mortgage to extend its amortization period and hence reduce the regular payment amounts could be a good idea even if you don’t receive a lower interest rate. The alternative of keeping your current mortgage may mean significant financial stress.
Breaking your mortgage to pay a large sum off the principal may cost you money now but if you keep your payments the same, you’ll pay off your home quicker and save interest in the long run. With interest rates as low as they are (and likely heading even lower), however, you might want to consider investing in the stock market instead.
Making the decision to break your mortgage is a complicated financial decision. We’ve presented a straightforward view of the key factors involved. We highly recommend that you consult an experienced mortgage broker for expert advice and peace of mind.
- Mortgage Prepayment Charge Calculator. Royal Bank
- Information on Mortgage Prepayment. CIBC.
- Breaking Your Mortgage Contract. Government of Canada.
- Should you Break Your Mortgage? MoneySense.
- Doing the Math on When to Break a Mortgage Contract. The Star.
- Mortgage Calculators and Tools. TD.
- Mortgage Prepayment Calculator. BMO.
- What you Need to Know: Mortgages and Mortgage Pre-payment Charges. Scotiabank.