A mortgage is a contract between a borrower and a lender. A mortgage is usually "closed" for a certain length of time. In Canada, mortgage terms can be as short as one year or as long as ten years. There are some "open" mortgage products, such as a line of credit that offer borrowers more flexibility to prepay with the ability to exit at any time. I explore these at the end of this article.
Closed mortgage products are locked in, and a borrower who enters a closed mortgage product promises to uphold their agreement for the length of the entire term.
If a borrower decides to break their mortgage contract or "break their mortgage" before this time, they have to pay a pre-payment penalty. The amount they pay depends on how much time remains in their term along with the type of interest rate they have, such as a fixed or variable rate. In a variable rate mortgage, the penalty is usually just three months' worth of interest regardless of how much time remains. A fixed-rate mortgage, on the other hand, gets calculated using the Interest Rate Differential or three months' worth of interest, whichever is greater.
Perhaps one of the most significant deterrents of refinancing for most people is having to pay a pre-payment penalty. Most people are afraid to ask what the penalty is and feel the burden of the costs associated with renegotiating their mortgage does not outweigh the benefit of refinancing.
Here are some things to think about:
Blend and Extend
Sometimes, a borrower can avoid paying the penalty in a refinance situation if they stay with the same lender. Most lenders can increase the amount of mortgage, and blend the old rate on the previous loan with the new interest rate on the additional funds requested. The time left remaining in the term stays the same, which means there is no penalty.
So, for example, a mortgage of $400,000 can be increased to $500,000 with the same financial institution, and the old rate of let's say 2.99 percent on the $400,000 gets blended with the new rate of 2.59 percent on the $100,000 requested. Therefore, the total new rate on the new blended mortgage amount of $500,000 is 2.79 percent, for example. The remaining time left in the term of the mortgage stays the same and therefore, there is no penalty.
Considering The Costs Of A Penalty.
Although most refinances trigger a penalty, it's essential to consider the benefits and risks and calculate whether the savings outweigh the penalty incurred.
If a borrower has substantial unsecured credit card debt, for example, then paying the penalty may be wiser than continuing to make interest-only payments on never-ending credit card balances.
For example, a borrower may pay over $4,000 in minimum payments to creditors each year, which over time, can add up to significant financial losses. Meanwhile, paying only a one-time $3,500 penalty may make more sense than continuing to pay interest-only on credit cards since, over time, principal owning on the mortgage debt gets paid down in addition to substantially lower interest on the entire balance. Compare mortgage rates to 23.9999% credit card interest.
In three years, the credit cards would have absorbed approximately $12,000 in interest-only payments, and the actual balances of those cards wouldn't have been reduced. Therefore, paying the penalty, in this case, is well worth it.
Line of Credit
There is one other way to avoid paying mortgage penalties, which is considering an "open" mortgage product like a line of credit. An open mortgage product does not cost money to leave and can be prepaid at any time.
A line of credit can get registered in "second" position, which means the existing first mortgage does not have to get broken or renegotiated. Meridian Credit Union and Manulife Financial, for example, both offer secured lines of credit (in the second position) exclusively through the broker channel to all applicable borrowers. If a borrower does not qualify, we also offer the Equityline Visa, which is perfect for those with bruised credit or not enough confirmable income, such as limited self-employed claimed income, for example.
In the alternative, a borrower should also explore a total equity plan which combines a closed first mortgage with a secured line of credit, both at competitive interest rates.
Do you require some financial restructuring? I am specialized in money-management and choosing optimal mortgage financing products.
Call or write today.
Sarah A. Colucci
Mortgage Agent Lic. M14000929
Mortgage Edge, Broker 10680
Direct: (647) 773-4849
** Our high-ratio mortgage rates are as low as 2.44% for a five-year fixed rate. Refinances as low as 2.59%. Conditions apply. Call or write for details.
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By: Sarah Colucci
Senior Mortgage Agent, Lic. M14000929