There are circumstances where it makes sense to bite the bullet and pay the penalty on your residential mortgage

Last week I reviewed the calculation of penalties on early payout of a residential mortgage. With mortgage rates at their lowest point in 40-years, mortgage holders would be remiss not to at least consider the possibility of paying a penalty to renew early. And there are circumstances where it makes sense to bite the bullet and pay the penalty but it also makes perfect sense to review alternatives before paying what will likely be big dollars on penalties.

One option is to blend the rate on your existing mortgage with rates currently being offered. In essence you are renewing your mortgage early at a rate that is lower than the rate you are now paying but higher than current rates. Early renewal is especially attractive if you believe current mortgage rates are low but you expect them to increase before your existing mortgage comes up for renewal – not an unreasonable expectation in today’s market.

To renew early you must have more than one year left on your existing term and the "renewed" term must be longer than the existing term.

Consider last week's example of a $100,000 mortgage at 7 per cent amortized over 20-years with 3 years left before renewal. The monthly payment on this mortgage is $775. Recall that the interest rate differential penalty (IRD) to be paid on discharge of this mortgage would be $2,985 assuming the posted rate on a three-year mortgage is 6 per cent.

Assume in this case, the individual is concerned that interest rates will be higher three years from now and wishes to extend the mortgage term to five years. Five-year mortgage rates posted on the net vary from a low of 5.50 per cent to a high of 7.05 per cent. For purposes of example let’s assume the borrower has a bit of financial clout and is able to obtain a rate of 5.65 per cent – this is the same five-year rate used in my article last week.

Using a five-year rate of 5.65 per cent and skipping the detailed calculation, the blended rate on this early renewal will be 6.46 per cent. If the monthly mortgage payment is kept the same, early renewal will generate an interest saving of $1,721 at the end of three years, being the date the initial mortgage would have come up for renewal. In other words, the borrower would have reduced their mortgage balance by $1,721 all without paying a mortgage renewal penalty of any kind; in essence the borrowed has paid himself/herself instead of the bank.

Broken down on a monthly basis the saving may appear to be small ($48 per month), however, all things being equal and rolling forward to the end of the 20-year mortgage amortization period, early renewal will have saved this individual almost $15,000 and reduced the mortgage amortization period by twenty-one months.

But even looking only to the end of “new” five-year period, the principal balance outstanding on this "renewed" mortgage would be $83,270 which is $2,987 less than the balance would be if we assume the same 7 per cent rate throughout the five-year period.

If we compare this with the alternative of paying the penalty and renewing the mortgage at 5.65 per cent for five years, the decision is clear. Assuming that the penalty would be added to the original mortgage balance, as noted in last week’s article, the principal outstanding at the end of the five-year term would be $85,783 which is more than $2,500 higher than the mortgage renewal amount achieved with a blended mortgage rate.

But what if you have the cash to pay the penalty up front thereby eliminating the need to add the amount to the mortgage principal? Should you discharge your existing mortgage or renew your mortgage at a blended rate. The answer may very well be neither. It could be that your best choice is to make a lump-sum payment on your existing mortgage and be patient. The only way to know for sure is to do some work with your calculator.

Most economic forecasts that I have seen indicate that interest rates may not have bottomed out and with the economies of the world slipping into recession it’s unlikely rates will be increasing in the very near future. In any event, if your calculations indicate that your best bet is to stay the course, you will still have the mortgage renewal card to play if interest rates start to move upward in the future.

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