Is breaking your mortgage for a lower rate worth the prepayment penalty?

  9/22/2024 |   SHARE
Posted in Mortgages and Real Estate by Vanguard Realty | Back to Main Blog Page

As interest rates continue to drop, borrowers might wonder if they should renegotiate their fixed-rate mortgage. But at what cost?

With both fixed and variable mortgage rates dropping rapidly, homeowners may be asking themselves a critical question: Should they break their current mortgage and pay the prepayment penalty to secure a lower rate?

While the allure of a lower rate is tempting, Matt Imhoff, founder of Vancouver-based Meticulous Mortgages, cautions that the way prepayment penalties are structured could catch borrowers off guard.

“If you tend to chase the lowest rates, lenders often make it up on the back end,” Imhoff tells CMT, adding that the cost to the borrower could be significant.

Understanding mortgage prepayment penalties
For most fixed-rate mortgages, the penalty for breaking the loan before the term ends is calculated using one of two methods: either three months of interest or the Interest Rate Differential (IRD), whichever amount is higher. The IRD is the difference between the interest you would have paid based on the posted rate at the time you signed your mortgage and the interest you would pay at the current posted rate.

This means that if posted rates decrease after you’ve signed your mortgage, your IRD penalty can increase. For example, if you signed your mortgage at a 5% interest rate and the posted rate drops to 4%, your IRD could be based on the 1% difference. If the posted rate drops further to 3%, the IRD would be calculated based on a 2% difference.

The purpose of the IRD is to allow lenders to recover some of the interest they would have earned if you had kept your mortgage until the end of its term. However, according to experts like Imhoff, lenders’ communication of these penalties can be unclear, making it difficult for borrowers to fully understand how much they owe.

“The big issue I see here is that lenders will not tell you what your IRD is when it’s less than three months’ interest,” he says. “You could be $2 away [from having to pay the full penalty, and] they’re not going to tell you.”

This lack of transparency can create significant financial burdens for borrowers unaware of how close they are to paying large penalties. When posted rates drop, many homeowners could fixate on the lower rate without fully understanding the hidden costs of the prepayment penalty.

In recent years, numerous cases have appeared in the media where borrowers have been hit with shocking prepayment penalties, sometimes reaching as high as $30,000.

One such case involved a real estate agent in Ontario, illustrating that even industry professionals, who are typically well-versed in real estate transactions, can be caught off guard by the steep penalties associated with early mortgage termination.

Discounted rate versus posted rate
Another potential source of confusion for borrowers is the difference between the posted rate at the time they sign their mortgage contract and the discounted rate they actually receive from their lender.

According to Imhoff, failing to recognize this critical distinction means losing the “superpower” of the discounted rate, which could otherwise provide significant savings.

“Say someone got a 5-year fixed rate two years ago, and let’s say the rate was 5.34%,” explains Imhoff. “A broker can go to that client now and say, oh, I can give them a new term that may save them $2,000 over three years.”

“But what that broker isn’t paying attention to is the posted rate when that mortgage originated,” he adds. “If we look back, because we’ve been tracking it, that posted rate might have been 5.99%, which would impact the IRD.”

The importance of education and communication
Imhoff explains that whether paying the prepayment penalty to refinance at a lower rate is worthwhile depends on several factors, including the remaining term of the mortgage, the borrower’s financial situation, and how much further interest rates are expected to fall.

Whatever the situation, however, brokers need to determine how prepayment penalties affect their clients’ goals. In particular, Imhoff says it’s vital that brokers help clients understand their IRD to determine where they stand on the risk scale.

“If you don’t understand penalties, the best time to learn about your IRD and your penalties was yesterday,” Imhoff tells CMT. “The second-best time is today. The earlier you understand where you’re at, the better you can plan.”

One of the most effective ways for brokers to assist their clients is by tracking the posted rates of lenders and communicating prepayment calculations to them quickly, enabling clients to make decisions based on up-to-date information.

“Educating our clients is huge,” Imhoff emphasizes. He notes that sometimes, brokers themselves are not paying attention to critical factors such as the mortgage loan agreement or tracking the posted rate or discount.

“The competitive advantage [at our brokerage] is that we’ve been tracking them daily for two and a half years,” he says, highlighting how important it is for brokers to stay informed and to pass that knowledge on to their clients.

Imhoff also emphasizes the importance of training programs for brokers, which can improve their ability to help clients navigate prepayment penalties. “At the end of the day, we should be there to help clients make better decisions,” he explains. “This is what we do with our training programs. We try to help brokers help those clients make better decisions.”

Managing penalties in a low-rate environment
With economists predicting more rate cuts on the horizon, borrowers may be tempted to break their current mortgage to take advantage of lower rates. However, Imhoff stresses that understanding prepayment penalties is crucial to making informed decisions.

And for brokers, communication is key to helping their clients. For Imhoff, providing clients with clear, accurate information can help homeowners grasp the complexities of prepayment penalties and make sound financial choices in today’s rapidly changing mortgage market.

Source: Canadian Mortgage Trends

Home Owners, Home Ownership, Mortgage Advice, Mortgage Consumers, Mortgage Interest Costs, Mortgage Trends, Variable Rate Mortgages