Though mortgages are an excellent solution for those looking to own a home, they haven’t been spared from the current state of the market. Within the last five years, Canadian mortgages have jumped from less than $300k to over $600k. Bank of Canada’s recent interest rate hikes is adding to the difficulties of managing the financial responsibility of a mortgage. These drastic cost increases have prompted some to investigate how to cut mortgage costs. Others are struggling so much they have no choice but to break their mortgage. No matter the reason, breaking a mortgage means facing a hefty mortgage breaking penalty.
What does breaking your mortgage mean?
Breaking your mortgage is just as it sounds: you are making changes or renegotiating your mortgage contract before the end of your term.
There are two types of mortgages, closed and open. If you have a closed mortgage, you cannot break it.
Though the option of breaking a mortgage is available for most open loans, doing so comes with a mortgage breaking penalty.
Why break your mortgage contract?
Homeowners could break their mortgages for many reasons.
Broadly speaking, homeowners will break their mortgage if the contract no longer meets their needs. If that is the case, you can make a new deal around your current contract.
Some of the main reasons one would break their mortgage are:
- Interest rates have decreased
- The homeowner’s financial situation has changed
- The homeowner wants to buy a new home and is planning on moving
- The homeowner’s family situation has changed
- The house no longer meets the homeowners’ needs
When does it make sense to break your mortgage?
One of the cardinal rules behind breaking a mortgage is when you can secure a new rate that’s at least 2% lower than your original mortgage. Though that has now changed. With rates becoming so low these days, switching for a much smaller decrease is now worth breaking your mortgage.
For example, if you have a five-year fixed mortgage at 5.0% and encounter a 3.39% rate. Though this seems small, it is actually reducing your rate by more than a quarter. This decrease could lead to a 30% reduction in your monthly payments. If your monthly payments were $1,500, you’d save around $450 monthly.
Of course, your new rate is only one part of the equation for deciding whether to break a mortgage or not. The other factor to take into account is your mortgage breaking penalty. Depending on how much the new rate cuts cost it may be worth taking the penalty hit.
The pros and cons of breaking your mortgage
As stated previously, the benefit of breaking your mortgage is that you can secure a contract that meets your needs. This includes getting a better rate or dropping out of the loan entirely as it doesn’t suit your current situation.
Here are some more pros to breaking your mortgage:
- Paying less interest over the term
- Lower monthly carrying costs
- Repaying mortgage faster than with the original contract
- Locking in lower rates can help you budget
The disadvantages of breaking your loan are a bit more complex.
- Pay mortgage breaking penalty fees
- Repay a percentage of any capital you received
- Could end up paying more after factoring in any fees paid
- Must pass the stress test
If you feel that incurring a mortgage breaking penalty isn’t worth the risk, you should consider some alternatives.
What are the differences between breaking a fixed vs a variable-rate mortgage?
The mortgage breaking penalty for a fixed rate versus a variable rate differs significantly.
Most variable-rate mortgages only charge three months interest penalty if you end up breaking the mortgage. With fixed-rate mortgages, the penalty fee is often much higher, usually by a few thousand dollars.
It is important to note that penalties will vary from lender to lender, regardless of whether it is fixed or variable.
What is the cost of breaking your mortgage?
There are many costs associated with breaking a mortgage. Many of the associated fees will be outlined in your contract.
The highest cost associated with breaking your mortgage will be the prepayment penalty. Prepayment penalties vary depending on your lender.
The prepayment penalty is usually calculated in one of two ways: 3-months of interest or Interest Rate Differential (IRD). An IRD compares the interest rates between two similar interest-bearing assets, typically between two interest rates.
An IRD is based on an interest rate that equals the difference between the mortgage interest rate and the interest rate that the lender charges when re-lending the funds for the remaining term of the mortgage.
A majority of fixed-rate mortgages usually have a prepayment penalty that is the higher of three months’ interest or the IRD. Most variable-rate mortgages have no IRD penalties.
Other costs associated with breaking a mortgage contract are:
- Administration fees
- Appraisal fees
- Reinvestment fees
- Mortgage discharge fees
You can find mortgage breaking penalty calculators online to get an idea of what you will pay.
How will the stress test affect you?
A mortgage stress test is mandatory for those breaking their mortgage to move to a new lender. If you break your mortgage but stay with the same lender, you do not have to do the stress test.
A mortgage stress test determines if you can pay your mortgage should interest rates rise. It provides rules lenders use to calculate a borrower’s qualification for a mortgage and how much they can borrow.
To pass the stress test, you must be able to afford your mortgage payments if the interest rate increases by 2%.
Alternatives to breaking your mortgage
It may be best to seek an alternative to avoid a mortgage breaking penalty and not pay excessive fees.
Here are some popular alternatives to breaking your mortgage contract:
Porting Your Mortgage – You can port your mortgage from your old home to your new one. Your principal amount, interest rate, remaining term, and amortization period will shift to your new home. This ensures you won’t have to repay a prepayment charge.
Take Equity Out of Your Home – You build equity in your home when paying your mortgage principal or if your property value increases. You can use this equity to get a lower interest rate by opening a Home Equity Line of Credit (HELOC).
Renew Your Mortgage Early – Depending on your contract, you can sometimes renew your mortgage early without paying a prepayment charge.
Breaking your mortgage has both its pros and cons. Before moving forward with breaking your mortgage it’s worth putting in a little effort to make an informed decision.
If you are looking to break your mortgage because you’re having a hard time making ends meet there may be another option. Our trained Credit Counsellors at Consolidated Credit can help form a plan to get you out of debt so you can stop the struggle. Reach out to learn more.