Rates, Rates, and More Rates
By: Melissa Kuczepa
Of course, we all know rates are incredibly low right now; and we also know that rates directly impact mortgage payments. So, why should rate not be your top concern? I know what I would have thought in the buyer’s shoes, “if my bank can offer me such a low rate, why can’t you”, or “why would my bank offer me something that won’t work for me?” Well, to put it simply, banks are in the money-making business.
A super low interest rate sounds fantastic up front, but is it as amazing as it sounds? Probably not. This interest rate is likely being offered on a 5-year fixed term mortgage. What does that mean? That means that for the duration of the term, your interest rate, and by default, your mortgage payment, will not change. This also means that if you need to change your mortgage during those five years, you will be charged the greater amount of three months interest, or interest rate differential penalties. For some people, this sounds like a great choice! You do not plan on moving in the next five years and you know exactly how much money you will pay each month. It provides a sense of security. But life can change in an instant and most borrowers find they need to break their term within the first 3 years and end up paying penalties to buy a new home or refinance their current one. Let’s explore this in more detail.
On a $375,000 mortgage, the difference between 2.00% fixed and 2.05% variable works out to around $9.31 monthly. Over the 5-year term, you would be looking at a total savings of $558.60 (assuming the Bank of Canada does not alter interest rates changing the variable rate). But those few dollars in savings could cost you thousands in the end.
If you were to encounter financial difficulties and wish to refinance your mortgage, you would be required to pay a penalty to break the term early. To break the variable rate mortgage, you would be charged 3 months interest only. But to break the fixed term mortgage, you will be charged the greater amount of either 3-months interest or the Interest Rate Differential penalty or IRD – this is where things can get expensive. IRD is calculated differently depending on the lender you use. There are generally three ways of calculating IRD: “standard”, using the bank’s POSTED rate which can be significantly higher than what they are offering borrowers, and by calculating the difference between any discounts they gave off your original interest rate versus the posted rate when you are breaking the term – which can increase the penalty even higher. **Always be mindful when signing a mortgage commitment that you familiarize yourself with how the lender will calculate your penalty should you need to break early. ** In this example, I will use the standard IRD penalty calculation which is (existing mortgage rate – lender’s current rate that most closely matches the remaining term) x mortgage balance x remaining term. If the borrower had 36 months remaining and a mortgage balance of $350,000 with interest rates currently at 1.80 for a 3-year term, the IRD penalty would be calculated as: (2.00-1.80)/12 x $350,000 x 36. The penalty would be $2100. To calculate three months of interest, we would use the calculation: (existing mortgage rate/12 months) x mortgage balance x 3 or (0.02/12) x $350,000 x 3 = $1750. In this case, the borrower would be required to pay the IRD since it is the greater of the two amounts. **Be advised, this is the standard calculation. When using posted rates, the penalty would be much higher. It is always best to contact your lender directly to have an exact penalty amount quoted. **
Remember, rate is only one line of your mortgage commitment, there are many other factors you need to consider. As previously mentioned, you should consider penalties to break early and how they are structured. But also, you should consider when and how much you can pre-pay toward your mortgage if you came into additional money (IE work bonuses or commission cheques etc.), what the lender’s customer service is like and how willing will they be to help you in the event you need it. And those are just a few considerations!
As a Mortgage Agent, I ask detailed questions to ensure I understand your WHOLE situation. I need to determine whether the mortgage I am going to recommend to you will make sense. If you tell me in two years you are interested in using your equity to buy an investment property, it does NOT make sense to put you into a low interest 5-year fixed product where you will pay THOUSANDS in interest rate differential (IRD) penalties when you do want to buy that property.
If you want a free, unbiased assessment of your mortgage needs, contact me today!