When you think of what you look for in a mortgage, was rate the first thing that came to your mind? It is the most common feature of a mortgage in which we all focus on. But is it truly the most important?
Let’s explore the features of a mortgage and why they are all important to consider when you are looking to purchase or refinance.
Prepayments
Every Canadian no doubt dreams about paying their home off in full, but few of us know how to do so when you have a 25-year amortization on your mortgage. Mortgage lenders typically allow prepayments on their fixed and variable rate mortgages. With prepayments, you can prepay an extra 15%-20% per payment! This can drastically reduce the amount you owe on your mortgage over the course of a few years. These same mortgage lenders also allow lump sum prepayments which can be 15%-20% of your original mortgage balance.
Let’s look at what happens if we simply increase our monthly payments.
*Calculations are based off a $400,000 mortgage at a fixed rate of 3.29% with a 5-year term and 25 year amortization, compounded semi-annually. *
| Regular | 20% per payment increase | |
| Payment | $1,953.00 | $2,343.60 |
| Interest paid over 5 years | $60,962.28 | $58,976.63 |
| Principal paid over 5 years | $56,217.72 | $81,639.37 |
| Mortgage balance after 5 years | $343,782.28 | $318,360.63 |
| Remaining years on the mortgage | 20 Years | 14 Years 2 Months |
As you can see by increasing your monthly payments during this 5-year term, you are in turn paying off your principal at an accelerated pace. By increasing the monthly payments by 20%, the home owner would be mortgage-free 5 years and 10 months sooner.
Penalties
When purchasing a home, it’s hard to estimate what the future holds – whether that be a job transfer, marriage, divorce, and so on. One of the costliest mistakes with purchasing is not knowing the true cost to exit that mortgage.
For a variable rate mortgage, which fluctuates with the market, the penalty is calculated as a 3-month interest payment, no matter how many years into the term you are. With a fixed rate mortgage, the penalty is calculated as the greater of 3 months interest, or the interest rate differential (IRD). IRD is defined as the difference between your current rate and the current market rate (Ex. If you are 2 years into your 5 year term, your IRD would be the difference between your current rate and a 3 year term rate (aligning with the remaining three years of the mortgage term). Once the mortgage lender has the
IRD, they crunch some numbers: they take the percentage difference, multiple it by your mortgage amount, then by how many months remain, and finally divide by 12.
This may not sound like much, but if you take this and apply it to the big banks you can be looking at a penalty multiple times that of other mortgage lenders. The big banks typically calculate penalties using posted rates, while most consumers have “discounted rates”. There are also products where the lender will offer their lowest rates but pair that with the highest penalty.
Let us compare two mortgages for their penalties after being 2 years into a 5-year term mortgage.
*Calculations are based off a $200,000 mortgage at a fixed rate of 2.99% with a 5-year term and 25 year amortization, compounded semi-annually. *
| Variable rate mortgage penalty | Fixed rate mortgage penalty | Fixed rate mortgage penalty with posted rate |
| 3 Months Interest | IRD – New current rate of 3.29 | IRD – Posted Rate (Utilized mortgage calculator of one of big 4 banks) |
| $1,399.62 | $1,699.93 | $6,675 |
As you can see the penalty can be costly if you break your mortgage term on a fixed rate with a large institution.
Rates
At the end of the day, most home owners focus on ensuring they secure the lowest rate possible. Let’s compare a few different rates and see how much a difference it makes to your payments.
*Calculations are based off a $200,000 mortgage with a 5-year term and 25 year amortization, compounded semi-annually. *
| Rate | % 3.39% | 2.99% | 3.19% | 3.39% |
| Monthly Payment | $925.07 | $945.47 | $966.10 | $986.96 |
As we can see from our calculations, the difference in payment from 2.79% to 3.39% (Difference of .6 %) turns out to be a difference of $61.89 per month or $2.06/day (that’s a Tim Hortons large coffee). Of course, this number may seem significant up-front, but if you consider if you pay this over the course of the 5 years you are looking at an overall amount of $3,713.40 – yet this is still lower than what you could pay on some mortgage penalties!
So, although rate may be an important component in your mortgage selection process, don’t forget the fine print details such as your penalty cost and your ability to utilize prepayments and pay off your mortgage faster.
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