Fixed mortgage rates continue to reach new depths. Some are now under 2.00% for the first time ever.
That’s great news for new homebuyers or those with an upcoming mortgage renewal.
It’s creating a dilemma, however, for those who are currently locked into a fixed term at a higher—in some cases a much higher—rate.
Anyone who got a default-insured 5-year fixed in December of 2018, for example, would have a rate near or above 3.39% (the average insured rate at that time, as tracked by RateSpy.com).
Fast-forward to today, and a new borrower could find that same mortgage at 1.99% (or lower in some provinces).
That’s a hefty interest cost difference. Today’s borrower would be paying $6,584 less interest over five years per $100,000 of mortgage debt, all other things equal.
But Is a Better Rate Worth the Penalty?
For those feeling trapped in a fixed rate above 3.00%, there is hope, but it depends a lot on your current lender.
Many borrowers don’t even bother breaking their mortgage due to potentially massive prepayment penalties. Recent news stories (like this one) of homeowners facing $30,000+ penalties effectively deter people from saving money.
Terminating a fixed-rate early usually means you’ll pay a penalty based on the higher of three months’ interest, or the Interest Rate Differential (IRD), a formula that compares your original interest rate to the rate a lender could re-lend the funds at today.
IRDs often run into four or even five-digit dollar amounts. Breaking a floating rate, on the other hand, usually involves a penalty of just three months’ interest.
How Much Prepayment Penalty Should You Pay?
With interest rates so low, it very well might make sense to break your mortgage and pay that penalty, even if it’s a big one.
Take the following actual example from one of our readers:
- Mortgage balance: $892,300
- Remaining Amortization: 24.75 years
- Option 1: Accept the bank’s “blend and extend” rate offer of 3.39%
- Option 2: Break the current mortgage, which entails a $32,000 penalty, and obtain a new mortgage at 2.29%
In Option 1, staying with her bank means she must swallow a 3.39% “blended” rate, which includes the dreaded IRD charge built in. By doing that, she ends up paying $140,070 in interest over the 5-year term. The mortgage balance at the end of the term is $766,467.
By choosing option 2, however, the borrower ends up paying just $95,222 in interest over the term thanks to the lower interest rate. She saves $6,400 on the penalty by making a 20% lump-sum prepayment before requesting discharge of the old mortgage.
Tip: Confirm with your lender how far in advance you must make a prepayment before requesting a discharge. Some lenders don’t credit prepayments made within 30 days of discharge in penalty calculations.
The lower interest rate compared to Option 1 results in a monthly payment savings of $385, which can be rolled back into the mortgage in the form of prepayments. The mortgage balance at the end of the term is $747,219.
So, despite the hefty penalty, today’s lower mortgage rate still allowed our borrower to come out ahead by $19,248 over five years.
Sitting down and doing this math can be profitable indeed, as this example shows. If you’re not able to run these kinds of scenarios, any competent mortgage advisor can easily do it for you.