Switch After 12 Months?

One of the advantages of variable rate mortgages over fixed rate mortgages is they are easier to get out of...or at least a lot cheaper. To get out of a fixed rate mortgage, you need to pay what’s called an Interest Rate Differential. Ultimately it’s a formula that most people won’t understand, which typically results in a ridiculous penalty to get out of the mortgage. Variable rate mortgages are a little more straight-forward in that the penalty to break them is three month’s interest. Still not a “cheap” exit but there are times where it makes sense to pay the penalty to break the mortgage.

One year ago, people were paying prime rate for new variable-rate mortgages and 18 months ago it was prime + 0.60%. Today, the market is down to prime – 0.70%, or thereabouts.

For those who got their mortgage 12-18 months ago, many wouldn’t even consider refinancing as an option. But, I would argue it could be a very financially smart option.

Let me illustrate.

First, let’s assume our hypothetical borrower has:

• A 5-year variable-rate term
• A $300,000 mortgage amount
• A 25-year remaining amortization

Now, suppose:

• Our homeowner's mortgage is at prime rate (2.75%) today
• She switches to a new variable-rate mortgage at prime – 0.70% (2.05%)
• Prime rate increases 25 bps on Sept. 8
• Rates then stay put until June 2011 (according to most economists)

Here are the results:

• Interest savings: $10,014 (hypothetical over 60 months)
• Penalty: $2,062 (three-months of interest)
• Discharge Fee: $250 (depends on lender and province)
• Net benefit of breaking early: $7,702 (roughly)

Remember, the savings is in the spread against prime so whether prime goes up or down over the remaining term of the mortgage, the savings is the same. For most people, saving thousands over 3-5 years isn’t exactly the worst idea. So, if you’re currently in a variable at prime rate or above, find a mortgage planner to see if it makes sense to switch.