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Mortgage rates in Canada have been quite competitive recently, with low-cost providers entering the market and interest rates in decline. With attractive rates beckoning, you may wonder whether it’s worthwhile to break your mortgage contract before the current term ends and switch to a different provider that’s offering a better rate.
In some situations, breaking your mortgage contract could save you thousands of dollars. But that’s not a given, even if your interest rate goes down significantly. That’s because there is a penalty for breaking a mortgage, and depending on the type and size of mortgage you have and the remaining time left on the term, those penalties could be in the five-figure range.
So how do you know if you should chase these lower rates? Here’s everything you need to know about breaking a mortgage, the cost to break a mortgage, and how to determine whether or not doing so will save you money.
What Does It Mean to “Break” a Mortgage?
When you obtain a mortgage to buy a home, the mortgage lender agrees to loan you a specific sum of money that you will pay back over a given period (e.g. 25 years) – which is called the “amortization.” But the contract that you make with the lender is for a shorter period of time – usually two to five years – which is called the “term.”
The details of your mortgage payments are in place for the length of that term. So, for example, you might pay a five-year variable rate of prime plus 0.5%, or a five-year fixed rate of 5%. Once the term is over, you must renegotiate the terms of payment with your current lender or find a new one.
If, however, you want to change the terms of your mortgage before the term is up, you must break your current contract—even if you stay with the same lender. And that can come with hefty penalties (more on that later).
Can you break your mortgage contract? It really depends on the contract with your lender, but in most cases, it's possible to break your mortgage contract. But as you’d expect with any contract, it’s not a simple matter to break a mortgage. In fact, some mortgage contracts cannot be broken at all – you need to read the fine print and consult your lender to find out if breaking your mortgage is even an option.
When Is It Worth Breaking Your Mortgage?
As mentioned above, there can be good reasons to break a mortgage, such as a significant drop in interest rates during the term, a change in your financial situation, or because you want to sell your house and buy a new one. Determining your ultimate goal will help you decide whether it's worth it to switch. Are you looking to lower your monthly mortgage payment? Or are you more interested in paying down your mortgage faster? Or did you decide to sell your current house and buy a new one? Or do you want to consolidate debt into your mortgage? All of these scenarios could impact whether or not it makes fiscal sense to break a mortgage contract with your current lender.
It really depends on your circumstances and your need to crunch the numbers to find out if the costs outweigh the benefits. In general, the rule is that if you find a mortgage rate that's 30 basis points lower than your current rate, a switch in mortgage lenders may be worth it. But it also depends on how much of your term is left and what the penalty is for breaking your mortgage. Do the math, and if it works out that you'll have more money in your pocket by switching, then go for it.
What Does It Cost to Break a Mortgage?
Assuming it is an option, you need to be aware of all the drawbacks that could come with breaking your mortgage. There are monetary costs and other implications for breaking a mortgage:
Prepayment Penalty Fees
When you break a mortgage, it is assumed you are prepaying the remainder of the outstanding mortgage early and then taking out a new mortgage. As such, you’ll be charged a prepayment penalty.
Most financial institutions now have online tools, such as a mortgage prepayment calculator, that will crunch the numbers for you. Say, for example, you have a $300,000 five-year fixed mortgage at 4% interest (with no discount off the posted rate) and decide to break it after two years of a five-year term. The new mortgage on the remaining balance of $285,446 is offered at a preferred rate of 2.49% for the next three years. In that situation, the calculator shows your prepayment fee would be approximately $12,930.
What's the Penalty for Breaking a Variable-Rate Mortgage?
For a variable rate mortgage, the penalty is three times the monthly interest. Say, for example, you have a $300,000 mortgage with a variable rate that’s currently 3.5%, and a monthly mortgage payment of $1,500. About $830 of that monthly payment goes toward interest charges and $670 toward the principal. Your prepayment penalty would, therefore, be $2,490 ($830 monthly interest X 3).
What’s the Penalty for Breaking a Fixed-Rate Mortgage?
The prepayment penalty on a fixed-rate mortgage is usually a fair bit higher—and the calculation is much more complicated. It is based on the outstanding mortgage balance, the number of months until the term is up, your old interest rate, any rate discount you may have received (compared to the posted rates), and the new interest rate. This amount is called the interest rate differential (IRD).
Other Costs to Breaking a Mortgage
Aside from hefty penalties, there are some additional considerations to breaking your mortgage:
You Must Pass the “Stress Test”
If you got your mortgage in 2017 or earlier, you may not be familiar with the new Canadian mortgage qualification standards, commonly known as the mortgage “stress test,” that were implemented at the end of that year. These rules affect how much money you can borrow. In essence, you must prove you can carry a mortgage with an interest rate about 2% higher than what your lender is prepared to charge you.
If you borrowed the maximum you qualified for prior to 2017 and your income has remained the same (or dropped), you may no longer qualify for the same size mortgage now once the stress test is applied. If that’s the case, you cannot break your mortgage unless you have the extra funds available to pay the shortfall.
You Must Repay Any “Cash Back” Amounts You Received
Some lenders now offer incentives to take out a mortgage with them by providing a certain percentage of the mortgage to the borrower in cashback. If you received these incentives, you must pay that money back to the lender before you can break the mortgage mid-term.
There could also be additional fees for mortgage administration, appraisal and reinvestment costs. Again, read the fine print and ask your lender!
How Much Can You Save?
You can figure out if you will come out ahead when breaking your mortgage by calculating how much you would save in interest, and then subtracting all the penalties and fees. If you end up with a positive number, you might want to consider moving forward and breaking the contract. If you get a negative number, it’s best to stick with your current contract.
Step 1 – Calculate Interest Savings
Use a mortgage payment calculator to determine how much money you would save in interest payments at the new mortgage rate.
In our example above, we looked at a $300,000 five-year fixed-rate mortgage of 4%, and a variable rate mortgage that currently sits at 3.5%, each with a 25-year amortization. Say you want to break the mortgage after two years, when the remaining principal would be about $285,000. (Your lender can tell you exactly how much you still owe on your mortgage.)
Plug in the remaining mortgage amount to the calculator and adjust the amortization and term appropriately. In our case, that’s a 23-year amortization (25-2) and 3-year term (5-2). At the fixed-rate of 4%, you’d pay $32,547.63 in interest by the end of the term; and at the variable rate of 3.5%, you’d pay $28,434.86 in interest (assuming the rate stayed the same for the entire term, although that is unlikely to be the case; rates could go up or down which would increase or decrease your interest charges).
Now change the interest rate on the calculator to 2.49%, and you’ll see you’d pay $20,158.30 in interest by the end of the term. That’s $12,389.33 less in interest over the next three years by switching from the 4% fixed-rate mortgage, and $8,276.56 less by switching from the 3.5% variable-rate mortgage.
|Comparing interest charges at different rates|
|Mortgage balance||Interest rate||Remaining amortization||Time left on the term||Total interest charges by end of term||Savings in interest charges if switched to 2.49% mortgage|
|$285,000||4%||23 years||3 years||$32,547.63||$12,389.33|
|$285,000||3.5%||23 years||3 years||$28,434.86||$8,276.56|
|$285,000||2.49%||23 years||3 years||$20,158.30||--|
Step 2 – Subtract Penalties and Fees
As we determined earlier using the mortgage prepayment calculator, the fee to break our $300,000 five-year, fixed rate mortgage at 4% after two years, to move to a mortgage with a 2.49% interest rate, is approximately $12,930. So, in this situation, you would not save money by breaking your mortgage, because the interest savings are slightly less than the penalty charges ($12,389.33 – $12,930 = -$540.67).
The penalty on the variable-rate mortgage, however, was just $2,490. In that situation, breaking the mortgage could end up saving you thousands of dollars ($8,276.56 in interest savings – $2,490 penalty fee = $5,786.56). Even if you had to pay $1,000 in administrative costs, that’s still a savings of nearly $5,000 over the next three years—which most people would find quite worthwhile.
Where to Find the Best Rates?
Before committing to a mortgage lender, start by shopping around for the lowest interest rate on the market. A good place to start is one of the best online mortgage lenders, as their rates are often rock bottom.
Or look at getting a mortgage with a credit union. For a credit union with stellar rates, Meridian is our top choice: their 5-year, closed fixed-rate mortgage is phenomenal at 2.59%, but they also offer a 5-year, closed variable rate mortgage at 2.90%. It's hard to beat those numbers, and as a provincially-regulated financial institution, Meridian has more flexibility than traditional banks when it comes to the mortgages they offer and approve. That means if you are worried about passing the mortgage stress test, Meridian will work with you to find flexible solutions, making it easier to afford your dream home.
Another consideration: should I get a fixed or variable mortgage? Again, this comes down to your goals and financial situation. If you prefer stability and knowing exactly what your mortgage payment will be every month, you may want to lock-in at a fixed-rate that will never change (at least, until the term is up). So if variable rates are going up and your financial situation has nose-dived, making the switch to a fixed-rate mortgage may be in your best interest. That way, you can make a budget that will help you live within your means.
But if you're okay with taking a little rollercoaster ride with mortgage interest rates, switching to a variable rate might be your best bet. Like fixed-rate mortgages, variable-rate mortgages have a set term (e.g. 5 years), but the interest rate fluctuates during your mortgage term. This can happen as often as every month, as it’s tied to whatever is happening with the rate set by the Bank of Canada. A big plus is that variable-rate mortgages tend to be a lower interest rate than a fixed-rate mortgage. According to the Mortgage Professionals Canada (MPC), the average difference between a fixed and variable mortgage rate in 2018 was 0.55%, which works out to about $85 per month difference in payments. Historically, VRMs cost less in interest over the mortgage amortization. So if you've got wiggle room in your budget and are content to ride the interest rate wave, switching to a variable rate mortgage could save you a bundle of money.
Should I Consolidate My Debt?
Maybe you're not looking to pay off your mortgage faster or lower your monthly mortgage payment. Perhaps your ultimate goal is to consolidate debt into your mortgage, and re-financing might offer a solution to paying high-interest fees charged by credit cards. You could reduce your interest payments from 18% (or more) typically charged by a credit card to as low as 2.49%. That's a drastic difference!
Again, it will depend on the amount of credit card debt and how much your pre-payment penalty will be for breaking the mortgage. If you have a fixed mortgage with 5 years left on the term, it might be a sky-high cost to break your contract. Instead, you may want to consider signing up for one of the best balance transfer credit cards in Canada (some offer 0% interest for several months!) or one of the best low-interest credit cards in Canada instead.
What Are the Risks?
As we've already discussed, there are downsides to breaking a mortgage. We've outlined a few of the pros and cons to breaking a mortgage:
|Lower interest rate = big savings||Fees (prepayment, administrative, other)|
|Pay off mortgage faster OR pay less in monthly carrying costs||Repayment of any cash back amount received|
|Save money on interest charges||Could pay more overall once all fees are accounted for|
|Must qualify with new mortgage "stress test" and may get approved for less|
To ensure your new agreement is air-tight, talk to your real estate lawyer and make sure that you read the contract too. This will help prevent any unwelcome surprises down the road.
Breaking a Mortgage: Next Steps
After crunching the numbers, if you find that breaking your mortgage could save you money, here’s how you can proceed:
- Shop around for the best rates possible. Meridian offers an incredible 5-year closed fixed mortgage at 2.59% and 5-year closed variable mortgage at 2.90%. Or if you want to dig deeper, read our article on The Best Online Mortgage Lenders in Canada.
- Contact your current lender to make sure you are permitted to break your current contract and have accounted for all fees correctly.
- Find out what fees (if any) the new lender will charge you for setting up the mortgage.
- Get pre-approved for the new mortgage with the alternate lender, as you will now have to pass the mortgage stress test.
- Once approved, the new lender will pay out your mortgage with your current lender and issue a new mortgage with them.
Once you’ve made the switch, you can think about what you’ll do with all the extra dough that you’ve saved!
Last Word: Save More!
So you've done the math and decided to make the switcheroo. There are still a few tips for saving mo' money when you negotiate your new mortgage contract.
First, ask if the interest is compounded monthly or twice a year. The less frequent, the better, and getting a mortgage with semi-annual compounding could save you a wack of cash.
Second, if you get a variable rate, ask how often the rate fluctuates. Does it go up and down monthly? There may be an option to get one that only changes every few months. That might work better for you if you want a little certainty in your life.
Lastly, ask about the prepayment options. This may not be on your radar, but it's kind of a big deal. Most lenders allow you to make “prepayments” (extra payments over and above your normal mortgage payment) up to a certain amount each year, usually between 10% to 25% of the mortgage principal annually. This allows you to pay a certain percentage of the original mortgage amount without penalty. Find out what that percentage is with the new mortgage lender! You might come into some cash and have extra moolah to plunk down on your mortgage — wiping out years from your mortgage amortization. Also, if you plan on switching mortgage lenders and have money lying around, make a prepayment on your mortgage before breaking the contract with your current lender. This will drastically reduce your penalty. If you don't have any money to do this, consider getting a one-day loan from your mortgage broker so your penalty will be less.
With these tips and tricks in mind, you'll feel prepared to take on the challenge of breaking your mortgage and switching to a new lender!
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