Early in 2020, we’ve witnessed a sudden drop in borrowing costs with the Bank of Canada lowering its Prime Lending Rate by over a full percent in a little over a month. In addition, the general trend of fixed mortgage rates has pointed downward over the past year, resulting in what appears to be a golden opportunity for Canadians to refinance their mortgage. But is it really a good time to refinance?
What’s A Mortgage Refinance?
A mortgage refinance occurs when you set up a new mortgage in place of one that already exists. It almost always involves a request for additional funds, which are included in the new mortgage. Because mortgages are complex products, the many variables and costs involved with refinancing can make it difficult to determine whether or not it’s the right option for you.
How Does A Mortgage Refinance Work?
The simplest way to refinance your mortgage is to do so at the end of your current term. This way, you aren’t subject to any prepayment penalties and you have the freedom to choose the type of mortgage and term you’d like going forward. All you need to do is decide how much money you want to add to your mortgage within the guidelines and negotiate the best interest rate you can. There will be set up fees, which will be discussed later, and you’ll need to qualify for the larger mortgage amount; otherwise, the process is fairly straightforward.
But what if you’re only 2 years into a 5-year closed mortgage term? This is where things get a bit more complicated and the case for refinancing isn’t as clear because you may be subject to a large prepayment penalty just to get out of your existing term. Even if current interest rates are lower than what you’re paying, it may cost you more to break the contract than you’ll save in interest on the new mortgage.
Mortgage Refinance And Home Equity
To qualify for a mortgage refinance, you must have sufficient equity built into your home. You can’t borrow more than 80% of your home’s value between your original mortgage and any new funds you wish to borrow. As a result, refinancing may not be an option for someone who has recently purchased their home unless they had contributed a substantial down payment. To illustrate, if your home is worth $300,000, the maximum mortgage amount is $240,000, 80% of $300,000.
What Are The Costs Of A Mortgage Refinance?
We’ve compiled the following list of the various costs of refinancing a mortgage. They may or may not apply to you, so it’s best to check with your lender first before making a final decision on refinancing.
Interest Rate Differential (IRD) Charge
If you’re in the middle of a fixed term when you refinance, you may be subject to a prepayment penalty known as an IRD. The IRD is a rather complex formula that represents the cost to the lender of you breaking the mortgage in the middle of the contract. Depending on current rates as well as the amount of your existing mortgage balance term remaining, the IRD could be significant, well into the thousands of dollars.
3 Month Interest Charge
Instead of an IRD, you may be charged a 3 month interest penalty for refinancing in the middle of your mortgage term. Adjustable rate mortgages (ARMs) often default to a 3 month charge, while with a fixed term, it’s usually the higher of the two (3 month vs. IRD).
When you refinance your mortgage, you’ll be expected to cover the closing costs. This may include a home appraisal, at the request of your lender, as well as legal fees. Because you’re setting up a new mortgage, the lender must update the current mortgage registration. This can be done through a lawyer and, in some cases, through an in-house title insurance process. Either way, expect to spend anywhere from $500 – $800 for setup fees and approximately $300 for an appraisal.
Blending a Mortgage
While the expense of breaking a mortgage to refinance can be steep, a feature known as mortgage portability can help to alleviate the costs or even remove them. Here’s how it works, using imaginary numbers.
Let’s say you have a $200,000 mortgage with 3 years remaining in a 5-year term. Your current interest rate is 3.79%. You ask your lender about exiting the current term to add $75,000 to the mortgage and start fresh with a new term and a rate of 2.79%.
Here’s the problem. Because your current mortgage rate is a full percent higher (3.79%), your lender informs you that the penalty to break the contract will be $7,500 (again, using imaginary numbers). Meanwhile, the annual interest savings on $200,000 (2.79% vs. 3.79%) is only $2,000. It will take you almost 4 years to make up the cost of breaking the contract. Also, who knows where mortgage rates will go in the future? They could go up, or they could drop even lower.
Instead of breaking the contract, your lender may advise you to blend the current mortgage using a blended interest rate. Instead of paying a penalty, the $200,000 will continue at 3.79% and the $75,000 being added to the mortgage will be at the new rate of 2.79%. Your overall interest rate will be somewhere in between, but closer to 3.79% as it’ll be weighed more heavily to the larger amount.
Your mortgage term won’t change. You’ll still have 3 years remaining on your original 5 years. When the 3 years is up, you’ll be eligible to renew into a new term at the best possible rate at that time.
If you find yourself in a situation similar to this one, understand that you may not be able to fully benefit from a sudden drop in interest rates. It may not be worthwhile given the penalties associated with breaking the term. However, having the ability to blend your mortgage can still make refinancing the best option.
3 Reasons To Refinance Your Mortgage This Year
Now that you know how a mortgage refinance works and have a better understanding of the potential costs involved, here are our top three reasons to refinance your mortgage this year.
If you’re planning to renovate your home this year and you need to borrow to get the job done, the cheapest and most sensible route may be to obtain a mortgage refinance. Drawing on the equity in your home will give you the lowest borrowing rates and possibly the most flexible repayment terms. Check with your lender to find out if it makes sense to refinance for this purpose.
Decreasing Interest Rates
As we mentioned previously, interest rates dropped significantly in 2020. As a result, it might be the opportune time to refinance your mortgage and lock in a much lower rate for years to come. If you’re coming to the end of your current term or you’re only subject to a small penalty such as a 3 month interest charge, it might be the best time to draw equity from your home.
These days, many are faced with an unexpected economic crisis and may be struggling to make ends meet. And while it’s impacted some more than others, all of us are feeling the need to strengthen our financial situation by saving more money and paying down debt. Suppose you’re carrying large balances on high-interest credit cards or are struggling to manage a large loan payment each month. In that case, you may want to consider a mortgage refinance to consolidate your consumer debt. This can help by reducing your interest costs while improving your monthly cash flow.
Final Thoughts On Mortgage Refinance
There are a lot of factors to consider before refinancing your mortgage. In addition to what we’ve already covered, there are other considerations. How much money do you need to borrow? If you only require an extra $5 – 10K, refinancing is not likely worth the setup fees. Instead, you’re better off taking out a small unsecured loan or line of credit. Then there’s your credit score. When you refinance, you’re initiating a new application for credit, much like when you first got your mortgage.
Your credit will need to be strong and your income sufficient to manage the new mortgage payment. You should think about all of these things before proceeding. Of course, the best advice we can give is to consult with a mortgage professional to find out if a mortgage refinance is right for you.
Tom Drake is an authority in Canadian personal finance. He is a financial analyst and has been writing about personal finance since 2009 at the award-winning MapleMoney. His work has appeared in MintLife, Canadian MoneySaver, and U.S. News & World Report, and has been quoted in The Globe and Mail, Yahoo Finance, and Financial Post.