As mortgage interest rates fluctuate throughout 2024, many homeowners are contemplating whether breaking their mortgage early is worth the penalty. The idea of locking in a lower rate and reducing monthly payments can be tempting, but the cost of breaking a fixed-rate mortgage can be substantial. Here’s a breakdown of when it makes financial sense to break your mortgage early, and when it might be better to stick with your current terms.
Why Break Your Mortgage Early?
There are a few key reasons why homeowners consider breaking their mortgage before the term ends:
Securing a Lower Interest Rate
One of the main motivations for breaking a mortgage is the potential to secure a lower interest rate, which could significantly reduce monthly payments. If rates have dropped since you locked into a fixed-rate mortgage, you might be able to refinance at a lower rate, saving thousands of dollars over the term of the loan.
Accessing Home Equity
As home values rise across Canada, some homeowners may want to access their home equity to pay off debts, renovate, or invest. Refinancing by breaking your mortgage can allow you to borrow against your home’s increased value, often at a lower rate than other types of loans.
Life Changes
Major life events like moving, divorce, or financial changes may necessitate breaking your mortgage early. If you’re moving to a new home and can’t transfer your mortgage, or if your financial situation has changed, you may need to rework your mortgage to suit your new circumstances.
Understanding the Penalties
Breaking a mortgage typically comes with penalties, which can be calculated in one of two ways, depending on your lender:
Interest Rate Differential (IRD)
The IRD penalty is most common for fixed-rate mortgages. It is based on the difference between your current interest rate and the lender’s current rates for a similar mortgage term, multiplied by the remaining balance and the length of the term. This penalty can be particularly high if rates have dropped significantly since you locked in.
Three Months’ Interest
For some fixed and variable-rate mortgages, the penalty is calculated as three months’ interest on your remaining balance. This method generally results in a lower penalty compared to the IRD, making it more attractive to break variable-rate mortgages.
Is It Worth the Cost?
To determine whether breaking your mortgage early makes sense, you’ll need to calculate the potential savings versus the cost of the penalty. Here’s how to approach it:
Calculate the Penalty
Start by asking your lender for an estimate of your mortgage-breaking penalty. Be sure to ask whether the penalty will be calculated using the IRD or the three months’ interest method, as this can significantly affect the total cost.
Estimate Your Savings
Once you know the penalty, calculate how much you would save by refinancing at a lower interest rate. Use a mortgage calculator to compare your current rate to the new rate and see how much your monthly payments would decrease. Multiply the monthly savings by the number of months remaining in your term to estimate your total savings.
Compare the Costs and Benefits
Subtract the penalty cost from your estimated savings. If the savings are greater than the penalty, breaking your mortgage could be a smart financial move. However, if the penalty outweighs the savings, it’s likely better to wait until the end of your term to refinance.
Scenarios Where It Makes Sense
Interest Rates Have Dropped Significantly
If you locked into a fixed-rate mortgage when rates were high and rates have since dropped considerably, the long-term savings from securing a lower rate may outweigh the penalty. For example, a homeowner with a 5-year fixed rate at 5.5% might benefit from breaking their mortgage early if they can secure a new rate of 4.2%.
You Have Significant Home Equity
If your home’s value has increased substantially, refinancing to access that equity might make sense, especially if you can lock in a lower rate on a larger mortgage. This can be particularly beneficial if you plan to use the equity to consolidate high-interest debt or make value-adding renovations.
Scenarios Where It’s Not Worth It
Minor Rate Changes
If the drop in interest rates is only marginal (for example, 0.5% or less), the savings might not justify the cost of the penalty. In such cases, it’s often better to wait until your mortgage term ends to refinance without penalties.
High IRD Penalties
If your mortgage lender calculates the penalty using the IRD method, the cost of breaking your mortgage can be prohibitively high. In such cases, even a significant drop in interest rates might not make it worth paying the penalty.
Other Considerations
Porting Your Mortgage
If you’re moving to a new home, some lenders allow you to “port” your mortgage, meaning you can transfer your existing mortgage to the new property without incurring penalties. This can be a useful option if you’re happy with your current mortgage terms but need to move for personal reasons.
Blending and Extending Your Mortgage
Some lenders offer the option to blend your current mortgage rate with the new lower rate rather than breaking the mortgage entirely. This allows you to take advantage of lower rates without facing the full penalty. It’s worth asking your lender if this option is available.
Conclusion
Breaking your mortgage early can be a strategic move in 2024, especially if interest rates continue to drop or if you need to access home equity. However, the decision ultimately depends on the penalty you’ll face and the potential savings. Carefully calculate the costs and benefits, and consult with a mortgage broker to explore your options. In many cases, it’s worth waiting until your term ends to avoid penalties, but if the savings are substantial, breaking your mortgage could be a smart financial decision.
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