Having a lower mortgage rate is always attractive but does it make sense to payout your existing mortgage

Maroney on Money for November 3, 2001

With the economy clearly on the skids it’s nice to know there is still a bright light out there – I guess it’s the old cliché, “every cloud has a silver lining”. Residential mortgage rates have hit 40-year lows and many people are considering swapping their current mortgage for a new one at a lower rate. I originally wrote on this subject over five years ago so I say it’s high time to revisit the issue of swapping an existing mortgage for a new, lower-rate model.

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? Not surprisingly the answer depends on the numbers.

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, in part, 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: three months interest and something known as the interest rate differential or IRD for short.

Usually the penalty is the greater of these two amounts but more often than not it all boils down to the IRD. In simple terms, the IRD calculation is designed to compensate the lender for the interest income foregone by letting the borrower 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 the mortgage.

The IRD is calculated as the difference between the present value of the remaining interest on a 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.

For purposes of example, assume that two years ago you borrowed $100,000 at 7 per cent locking in for five years. At the time, you chose to amortize this loan over 20-years giving you a monthly payment of $775. As of today, your outstanding debt sits at $95,070 and you have three years remaining before this loan is up for renewal. If you leave things alone you will owe the bank $86,256 at the end of five years.

Assume further that the current posted interest rate on a three-year mortgage is 6 per cent. The IRD penalty in this case would be approximately $2,985.

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 $86,844 at the end of the remaining three-year period assuming the three-year interest rate is 6 per cent and the mortgage payment remains the same. Compared to the do nothing option, the borrower will actually owe an additional $588 ($86,844 less $86,256) at the end of the remaining three-year period. Clearly, suffering the IRD penalty in this case is not to the borrower’s advantage.

But that’s theory – in the real world there are several factors that can make a difference to this outcome.

Firstly, few borrowers will agree to pay a prepayment penalty simply to enter into a mortgage term that coincides with their original mortgage term. In the above example, it is unlikely that the borrower would opt for a three-year term; the borrow is far more likely to choose a five-year term – in effect squeezing out an extra two years at the lower rate.

Fair enough but aren’t five-year mortgage rates higher than three-year mortgage rates?. Yes they are but what really matters here is the difference between the actual rate and the posted rate. The IRD calculation is based on the posted rate whereas your mortgage renewal rate is likely to be lower than the posted rate. In today’s competitive market, it should be possible to knock a point or more off of the lender’s posted mortgage rates. Indeed, a quick tour around the net tells me that I can arrange a five-year mortgage for a 5.65 per cent – 0.35 per cent lower than the posted three-year rate. Using this amount and reworking the above numbers, I find that the borrower will owe only $85,783 at the end of year three – roughly $1,061 less than the do nothing option, even after adding the IRD to the outstanding principal.

Secondly, depending on the borrower’s circumstances, it may be possible to negotiate a reduction in the IRD penalty otherwise calculated. Did I mention that the current mortgage market is very competitive? If the lender wants your business, they may be prepared to bend on the penalty otherwise calculated. But you’ll never know unless you ask.

Thirdly, by renewing today, it may be possible to consolidate several higher-rate debts (e.g., car loan, credit card) into a single, lower-rate debt. The interest saving achieved by consolidating debt in this manner can easily offset the prepayment penalty imposed.

Fourthly, renewing early provides the borrower with certainty for a longer period of time – by locking in for a term longer than the original term, the borrower knows what the interest rate on the debt will be and the amount of the period payments for an extended period.

Finally, if a borrower finds their current mortgage somewhat restrictive, renewing can open up the door to build in flexibility with a new and improved mortgage.

If you’re considering re-working your existing mortgage, find a lender that is prepared to do the calculations to determine whether payment of a penalty is to your advantage and how best to restructure your debt. The mortgage world can be pretty complicated and not particularly well suited to do-it-yourselfers. This is where the services of a mortgage broker can be invaluable.

Jim Maroney is a chartered accountant with Andrews Brown Maroney in Maple Ridge.