This article has been updated from a previous version.
The decision to refinance your mortgage offers both opportunities and challenges. Despite its relative complexity, it’s drawing more interest from Canadian homeowners. RATESDOTCA data collected from May 2022 to 2023 showed that the number of people quoting for mortgage refinances rose by 17%.
Before taking the leap and breaking your mortgage, here’s what to consider when making this decision about your mortgage strategy.
In this article:
- What is mortgage refinancing?
- How much can I borrow through a refinance?
- How often can I refinance?
- Reasons for refinancing
- How to qualify for a mortgage refinance
- How much refinancing can save you
- When do I need to pay a pre-payment penalty, and how much is it?
- How to avoid penalties with pre-payment privileges
- Alternative to refinancing - home equity line of credit
- Tips for refinancing
What is mortgage refinancing?
Refinancing is a process whereby a homeowner replaces their current mortgage with a new one to pay off the remaining balance in full. It involves breaking their existing mortgage agreement and taking out another with new loan terms and conditions.
How much can I borrow through a refinance?
Typically, you can borrow up to 80% of the appraised value of your home, subtracting the remaining balance of your home. The amount you borrow through a refinance can also be influenced by your creditworthiness and the lender’s policies.
For example, if your current mortgage is 40% of your home’s value, then you can borrow the remaining 40%, bringing the total amount of your mortgage loan to 80% of your home’s value.
How often can I refinance?
There is no standard number for how many times you can refinance your mortgage. However, your lender will typically set a limit. The general rule is to have 20% equity or more in your home for a cash-out refinance.
Why you may choose to refinance
According to the 2023 CMHC mortgage consumer survey, 19% of homeowners refinanced their mortgages, mostly to consolidate debts or to undertake renovation projects.
Financial situations can drastically change at any moment. Maintaining a mortgage can be challenging, particularly when faced with rising interest rates and disruptions or changes in income. Here are some reasons why you may consider refinancing your mortgage:
Capitalizing on low interest rates: With the recent hikes in interest rates set by the Bank of Canada (BoC), homeowners may find themselves facing higher borrowing costs. Those who recently entered the housing market or are approaching mortgage renewals may consider refinancing to potentially capitalize on future rate drops.
Accessing home equity: Refinancing can help homeowners access any accrued home equity. Refinancing allows you to leverage increased property value, freeing up more money for things like home improvements.
Adjusting mortgage type: You can refinance to extend your mortgage amortization to lower your monthly mortgage payments, or switch from variable-rate to fixed-rate or vice versa.
Consolidate debt. If you have debts with high interest rates, think about merging them with your mortgage. Mortgages usually (aside from recent rate hikes) have low interest rates (much lower than the average 20% rates on credit cards), so you could potentially save on interest payments.
Buying an investment property. The down payment requirement on an investment property is often heftier than a principal residence. You only need 5% upfront to buy a home (if you’re buying a property under $500,000) compared to a 20%+ down payment on a non-owner-occupied rental property.
So, if you don’t have the cash on hand, consider refinancing the mortgage on your primary residence and pulling equity out to use as a down payment on the investment property.
Related: Should I refinance my mortgage?
How to qualify for a mortgage refinance
Here are the key requirements to consider when refinancing your mortgage:
Home ownership duration: The type of mortgage you have and the amount of equity you have in your home will determine your pre-payment penalty. If you have a closed mortgage, the fees you’ll incur will depend on how much time is left in your mortgage.
Credit score: You’ll typically need a credit score of at least 640-680.
Home equity: The minimum requirement is 20% equity.
Debt-to-income ratio: This is calculated by combining all your recurring monthly debt and dividing it by your gross monthly income. You’ll usually need a number that’s 50% or lower.
Mortgage stress test: You have to pass the stress test to determine your ability to repay your refinanced mortgage – if interest rates increase.
How you can reap savings by refinancing
Let’s assume that your current mortgage has an interest rate of 5.5% and you’re able to potentially refinance at 4%. If your home is worth $757,600 — the average home price in Canada — and you have exactly 20% equity in it, then you will require a new mortgage of $606,080.
For the sake of this article, let’s say that you have 20 years left on a fixed-rate mortgage.
Using the RATESDOTCA mortgage payment calculator, you can assume that at a rate of 5.5%, you will pay $4,148 monthly over a term of 20 years. This will amount to $995,510.09 in total, including $389.430.09 in interest.
In contrast, if you were to refinance that same mortgage at 4%, you would be paying $3,662 monthly over 20 years.
This would amount to $878,932.07 in total over the course of the loan, with $272,852.07 going to interest.
That means that before accounting for any additional fees that you would incur from refinancing your mortgage, you would save $116,578.02 or $5,828.90 per year over the course of your mortgage by refinancing at just 1.5% lower.
Related: 24% of Canadian homeowners expect home equity to fund at least some of their retirement: survey
When do I need to pay a pre-payment penalty, and how much is it?
Your mortgage lender may charge you a pre-payment or breakage fee if you do any of the following:
- Pay more than the allowed amount toward your mortgage
- Break your mortgage contract
- Transfer your mortgage to another lender before finishing your term
- Pay back your entire mortgage before the end of your term, including when you sell your home
Penalties differ across lenders and depend on the mortgage type and terms– whether it’s fixed or variable, five- or ten-year, your existing rate, and rate type, among other things.
Variable-rate holders pay the first three months of interest as the pre-payment penalty. With fixed-rate mortgages, the pre-payment fee is either three months of interest on the amount prepaid or the interest rate differential (IRD). The latter will typically be opted for if the interest rate on your mortgage is higher than the current interest rate and if you signed your current mortgage contract less than five years ago.
IRD is the difference between the remaining interest left on your original fixed rate loan and the amount of interest you will be charged on the new variable rate loan.
Pre-payment penalty example
- Outstanding mortgage amount: $500,000
- Current interest rate: 6%
- Number of months left in term: 36 months left in a five-year term
- Current posted interest rate for a mortgage with a 36-month term offered by lender: 4%
Your proposed pre-payment penalty fee comes to either $22,500, which is three months’ worth of interest on what you still owe, or an IRD of $30,000, which is the higher of the two amounts.
Keep in mind, you may also have to pay other additional fees such as, any legal and appraisal fees, mortgage application fees, and broker fees.
Skip the penalties with pre-payment privileges
Pre-payment privileges allow you to pay off your home loan faster, as long as it's explicitly outlined in your mortgage agreement with your lender. Without this inclusion, opting for accelerated payments can result in penalties.
The exact terms of your pre-payment privileges vary depending on your lender but can take the form of lump sum payments, regular installments, or both for up to 10 to 20 per cent. The pre-payment amount would be subtracted from the remaining principal balance on the loan.
Not sure about refinancing? Look into a home equity line of credit
There are a handful of compelling benefits to refinancing. It provides fixed terms with regular monthly payments over the mortgage term, appealing to homeowners seeking stability and a one-time financial boost.
However, it’s not the only option available to homeowners who want to tap into their existing equity. A home equity line of credit (HELOC) is a flexible line of credit where homeowners can borrow against their home equity as needed.
This revolving credit line offers variable interest rates and a more adaptable repayment structure, making it suitable for ongoing expenses or projects with fluctuating costs. You must hold at least 20% equity in your home to access a HELOC and the maximum credit limit is 65% of the home’s market value.
Your first mortgage remains unchanged with a HELOC whereas, with a cash-out refinance, you get a new mortgage. Choosing between the two depends on factors such as the immediacy of financial needs, preference for interest rate stability, and the nature of expenses.
If you’re merging your debts through a HELOC, be careful. HELOCs only require you to pay the interest, which might lead you to not reduce your debt as quickly. This error can keep people in debt for a long time, even decades.
Read more: Which one is right for you - Home mortgage or HELOC?Tips for refinancing
Here are three tips for refinancing:
Know what to expect with a refinance. Refinancing your mortgage is like applying for a new mortgage. The lender will fully underwrite your application. This means you’ll need to provide letters of employment, pay stubs, tax documents, your most recent mortgage statement, property tax bills and other relevant documents.
Apply for pre-approval once you’ve selected a lender. This lets you know how much you can borrow and streamlines the borrowing process.
Shop around. Although lenders don’t typically cover your mortgage penalty, some lenders or brokers may cover other costs associated with refinancing, such as appraisal and legal fees. This reduces your out of pocket expenses and lowers your break-even point.
While your local bank may be a good first stop, you may potentially leave hundreds or thousands of dollars on the table if you don’t shop around. Do your own due diligence to compare rates online and make sure that the rate you’re being offered by your bank is competitive.
Read more: Mortgage renewals and the stress test: How it works
Compare Mortgage Rates
Engaging a mortgage broker before renewing can help you make a better decision. Mortgage brokers are an excellent source of information for deals specific to your area, contract terms, and their services require no out-of-pocket fees if you are well qualified.
Here at RATESDOTCA, we compare rates from the best Canadian mortgage brokers, major banks and dozens of smaller competitors.
