Breaking a mortgage can be costly

Friday, June 19th, 2009

Looking to lock in today’s low rates? There are ways to save money, but no substitutes for advice, expert says

Derrick Penner

Homeowners looking to break their mortgages to save money should beware: It can be expensive.

Whether it is an attempt to take advantage of lower mortgage rates or financial stress forcing someone to get out of homeownership, terminating a mortgage during its term can trigger penalties, said John DeRose, director of mortgage development managers and brokerage at Vancity.

“Not every mortgage is going to come with a penalty,” DeRose said in an interview.

“There are products such as open mortgages that allow you to pay off [the loan] with no penalty, and many lines of credit are open that you can pay off with no penalty.”

However, borrowers who take out fixed-rate mortgages, depending on the interest rate and the length of term, can typically expect breaking the mortgage to cost them.

There is usually a penalty clause that states the borrower will pay a penalty that is equal to either three months’ interest on the loan, or the interest rate differential — that is, the difference between the rate in their current mortgage and the new, lower rate — for the balance of the mortgage’s term, whichever is greater.

If a borrower breaks a five-year mortgage taken out two years ago, that would mean paying a penalty equivalent to the interest rate difference for the remaining three years.

And as fixed-term mortgage rates dropped as low as 3.75 per cent for five years in recent weeks, more borrowers were running into cases where the interest rate differential was substantially higher than the three-month interest penalty.

For example, DeRose said, a borrower with a $300,000 mortgage on a five-year, 4.75-per-cent term may want to break it after two years to obtain a 3.75-per-cent rate.

That would trigger an interest-rate-differential penalty of some $9,000. The three-month penalty on that 4.75 per cent, however, would be $3,600.

“Once these five-year mortgages hit under four per cent, that’s when the [interest rate differential] hit for many of these mortgages,” DeRose said.

Those five-year rates have started to crawl back up. Regardless, DeRose said borrowers may have other options than chasing lower interest rates to reduce their mortgage costs.

DeRose said many mortgages come with options such as the ability to accelerate payments, or make bulk payments of up to 15 to 20 per cent of the principal per year without penalty, which helps reduce overall costs.

His biggest piece of advice is for borrowers to diversify their mortgages. Take out a portion at a fixed rate and a portion at the variable rate, so that you can still get the benefit of lower variable rates, but only a portion of the loan will be at risk in case rates rise.

He added that many financial institutions offer “blend and extend” options.

In these cases, the borrowers don’t get to break the mortgage, but can secure today’s low rates for a period of time without paying a penalty if they are willing to extend the term of their mortgages.

In other words, instead of breaking their mortgages after two years of a five-year term and paying a hefty penalty, the borrowers agree to extend the term back to five years, pay the old, higher interest rate over three years, then pay the new lower rate for two years.

However, when it comes to weighing options for dealing with a mortgage, “advice is No. 1,” DeRose said. “Get in there and look at your alternatives, discuss them. There are ways to minimize that payment.”

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