When Does it Pay to Break Your Mortgage

With mortgage rates at “emergency” levels – low rates not seen by your parents and possibly even your grandparents – chances are you’ve considered breaking your current mortgage and renewing now before rates start to rise.

Perhaps you want to free up cash for such things as renovations, travel or putting towards your children’s education? Or maybe you want to pay down debt or pay your mortgage off faster?
If you’ve thought about breaking your mortgage and taking advantage of these historically low rates, feel free to give me a call to discuss your options.

In some cases, the penalty can be quite substantial if you aren’t very far into your mortgage term, but we can determine if breaking your mortgage now will benefit you long term.
People often assume the penalty for breaking a mortgage amounts to three months’ interest payments so, when they crunch the numbers, it doesn’t seem so bad. In most cases, however, the penalty is the greater of three months’ interest or the interest rate differential (IRD).

The IRD is the difference between the interest rate on your mortgage contract and today’s rate, which is the rate at which the lender can relend the money. And with rates so low these days, the IRD tends to be greater than three months’ interest. Because this is a way for banks to recuperate any losses, for some people, breaking and renegotiating at a lower rate without careful planning can mean they come out no further ahead.

Keep in mind, however, that penalties vary from lender to lender and there are different penalties for different types of mortgages. In addition, the size of your down payment and whether you opted for a “cash back” mortgage can influence penalties.

While breaking a mortgage and paying penalties based on the IRD can result in a break-even proposition in the short term, if you look at the big picture, you’ll see that the true savings are long term – as we know that rates will be higher in the years to come. Your current goal is to secure a long-term rate commitment before it is too late, and here lies the significant future savings.

Following is an example of a home that cost $250,000 in November 2008 (just months ago) and what it’s worth now, as well as the average change in interest rates, and total savings based on a 25-year amortization:


November 2008
Purchase Price: $250,000
Average Interest Rate: 5.84%
Monthly Mortgage Payment: $1,575
Amortization: 25 years
Total Interest Paid Over 25 Years: $225,000

vs.

May 2009
Purchase Price: $212,500
Average Interest Rate: 3.64%
Monthly Mortgage Payment: $1,076
Amortization: 25 years
Total Interest Paid Over 25 Years: $112,000

Using the above example, you would have saved $113,000 in interest payments alone over 25 years. Imagine the comparison using a higher-end home as an example.