The mortgage penalty box – the potential cost of lending and ‘blending’

Are low mortgage rates capturing your attention these days? If you already have a mortgage at a higher rate than those currently available, you may be considering refinancing to take advantage of a lower rate. But is that always a good idea? It’s almost guaranteed that you’ll run into penalties and pre-payment charges – they are nearly universal in the Canadian mortgage market – that could offset any gains you might expect.

Here are some things you should know so you won’t find yourself in the mortgage penalty box.

Why do I have to pay a pre-payment or penalty charge for refinancing my mortgage? When your mortgage lender provided your fixed-rate loan to you, they matched your loan against a funding source that was available to them. For example, if your mortgage term is for five years, the funds may have been sourced from the five year term deposit of another client. Your lender has the obligation to pay the term deposit holder the agreed rate of interest for the entire five years. If interest rates have declined during that period and you seek to refinance your mortgage loan, your lender will not be able to replace your paid-out mortgage at the same rate, but will still have to pay the ‘funding source’ – the term deposit holder – at the agreed interest rate.

The pre-payment charge, or penalty, is meant to compensate the lender for income they have lost and other costs associated with the early payout of your mortgage.

What kind of penalties can I expect to pay? All major banks and mortgage lenders typically levy pre-payment charges of either the greater of 90 days interest or the Interest Rate Differential (IRD). The IRD is based on the amount you prepay and an interest rate that equals the difference between your original mortgage interest rate and the interest rate your lender can charge today when re-lending the money. In a declining interest rate environment, the IRD can add up to thousands of dollars.

When can it pay to refinance my mortgage? If you are within the first three years of a five year term, the impact of ‘blending’ your existing mortgage interest rate into a new rate and extending the term portion of your new loan may prove to be a ‘wash’ – no win, no loss.

However, it is possible to take advantage of a lower rate if you are planning to refinance and add significantly to your mortgage amount. In this situation, the new, lower rate would apply to all of the ‘new money’ portion and the extended term portion of your new loan. The effect is that your blended rate becomes significantly lower. Some lenders will reduce the penalty amount for clients that refinance with them. Additionally, some lending institutions offer occasional promotions that assist with the payment of penalties when the mortgage is being transferred to them from another lender.

Refinancing your mortgage might be the right cost-saving move for you. But to be sure, talk to your professional advisor who may also be able to help you find a lending source that won’t put you in the mortgage penalty box.

This column, written and published by Investors Group Financial Services Inc. (in Québec – a Financial Services Firm), presents general information only and is not a solicitation to buy or sell any investments. Contact a financial advisor for specific advice about your circumstances. For more information on this topic please contact your Investors Group Consultant.
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