Should You Break Your Fixed-Rate Mortgage Contract?
Are you thinking about breaking your fixed-rate mortgage? While traditionally considered a financial faux-pas, many Canadians choose to break their fixed-rate mortgage when they find their current terms and conditions no longer meet their needs.
“Breaking a fixed-rate mortgage occurs more often than you would think,” Jared Ksenica, Regional Vice-President, Mortgage Specialist, with BMO Bank of Montreal said.
Of course, there are penalties to pay for breaking a mortgage. When you break a mortgage contract, the penalty is supposed to cover the lender's costs related to unwinding the loan, while also recouping part of their lost profit. The amount is dependent on the interest rate and the mortgage balance.
According to Ksenica, some of the most common reasons for breaking a mortgage include refinancing for debt consolidation, purchasing a second property and helping children with their education or helping them buy a home.
Another reason to break a mortgage is to take advantage of a lower interest rate. If you've been watching rates lately, you may be wondering if you could break your fixed-rate mortgage to save money in the long-term with a cheaper interest rate.
This may sound like a good idea, but be forewarned: trying to figure out what you'll be charged for breaking a fixed-rate mortgage is very difficult, with homeowners often miscalculating the cost of their penalty.
What are the advantages of breaking a fixed-rate mortgage?
John Tarnowski, Executive Vice President, Retail Financial Services at ATB Financial, says it's important customers look beyond the rate and compare the full mortgage package to determine what's best for them.
“If moving to a variable or new fixed-rate term will save interest costs over the remaining mortgage term, it might be worth doing, even if they have to pay a prepayment penalty,” he says. “If a person’s life or lifestyle has changed, it might also be a good time to consider this option.”
These kinds of decisions shouldn’t be taken lightly and it’s best to discuss options with a mortgage specialist. Despite paying the penalty upfront for breaking a mortgage, there may or may not be effective savings in the long-term—especially if you're facing high penalties.
What are the penalties for breaking a mortgage?
The biggest disadvantage of breaking a mortgage is the out-of-pocket penalties. And they're often much, much higher than you might have anticipated.
Fixed-rate mortgage penalties are always calculated based on whichever is greater: “the greater of a) three months interest or b) the interest-rate differential (IRD),” with the IRD being the difference between the existing mortgage rate and the interest rate currently charged.
However, there are key differences in the actual rates lenders use to calculate your IRD and this can greatly impact your penalties. The Standard IRD is what most people think of when breaking a mortgage, whereby the lender takes the difference between your contract rate and their current rate that most closely matches your remaining term.
But there's also the Discounted Rate IRD Penalty (used by RBC, BMO, TD, Scotia and National Bank). Banks who use this IRD format take your contract rate, compare it to the posted rate that most closely matches your remaining term and then subtract the original discount you got off of their five-year posted rate.
This small tweak that can make a huge difference in terms of the penalties you can incur. Using this calculation, it's possible for an IRD to jump from the Standard $1,500 to $9,000.
The Posted Rate IRD Penalty (used by CIBC) can have even steeper penalties. In this variation, the bank calculates your IRD penalty using the five-year posted rate they offered when you initially got your mortgage.
Get informed about the penalty calculators your particular lender will use before signing any mortgage contract so there are no nasty surprises down the road.
If you decide to break your fixed-rate mortgage but you want to stay with the same lender, ask if they offer penalty discounts. While not all lenders offer this type of incentive, some may be willing to reduce your penalties if you decide to stay with them. mortgage contract but still stay with them. In this case, Tarnowski says you can break your mortgage “in conjunction with a new mortgage,” minimizing the penalty by making a lump sum payment on their mortgage.
Be sure to check out our affordability calculator to find out how much you can afford and use our handy mortgage calculator to determine your ideal amortization period and down payment options.
The article above is for information purposes and is not financial or legal advice or a substitute for financial or legal counsel.
by Mario Toneguzzi