Current Mortgage rates are approaching 30 year historical lows and many people are considering swapping their current mortgage for a new one at a lower rate.
Crystal ball readers often opt for mortgage swaps if they believe rates will be higher when they renew.
Having a lower mortgage rate is always attractive but does it make sense to payout your existing mortgage to lower the interest rate you're being charged?
A mortgage is an agreement between a borrower and a lender. If, as the borrower, you wish to break the agreement the lender is going to charge you a penalty. Whether it pays to swap mortgages will depend on the penalty charged by your lender to let you out of your agreement. Most lenders use one of two methods to calculate the applicable penalty.
Probably the most common method of calculating the penalty is the interest rate differential (IRD). In simple terms, the IRD calculation is designed to compensate the lender for the interest income foregone by letting you renew at a lower rate. In effect, the lender is receiving payment of the interest difference today rather than receiving payment over the remaining term of your mortgage.
The IRD is calculated as the difference between the present value of the remaining interest on your current mortgage and the present value of the interest due on a new mortgage over the same term using today's lower rate. The key point to notice is that the lower the current mortgage rate used in the calculation is, the higher the IRD penalty will be. In other words, if you expect the interest rate you are paying to drop significantly, you should also expect to pay a large IRD penalty.
Assume that you currently owe $100,000 at 9 percent amortized over 20 years with a remaining term of three years. The current interest rate on a three year mortgage is 8.00%. The IRD penalty in this case would be approximately $2,437.
Since borrowers will not likely have this kind of cash freely available, they will have to add the penalty to their existing mortgage. In doing so, the borrower will be left owing essentially the same amount at the end of the three-year term assuming the mortgage payment remains the same. Clearly, the borrower is no better off at the end of the day.
Another method used by lenders is to assess a penalty equal to three months interest. Using the same mortgage terms as above, the penalty would be approximately $2,206. Even adding the penalty to the remaining debt while keeping the mortgage payment the same, the borrower will be better off than under the IRD example above.
In general, the three month penalty is most attractive to the borrower the longer the remaining term of the mortgage. The problem is, however, that many mortgage documents are drafted so that the penalty is actually calculated as the greater of the IRD and three months interest so you may not have a choice in the matter.
The truth is there are alternatives to paying either of the above penalties but you'll have to wait until next week.
BILO PRESS
Maroney on Money for June 9, 1996
Jim Maroney is a chartered accountant with Andrews Brown Maroney Chartered Accountants in Maple Ridge.
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