Should you break your 5 year fixed rate mortgage?

Tom, a client, just popped in to ask us a question. It is a question that we have been asked many times lately. So much so, I wanted to take a moment to answer the question with my favourite language: math.

The question “is it worthwhile to break my 5.5% fixed rate mortgage and pay the penalty to get one of those ultra low fixed rate mortgages now available?”

The quick answer is “no”, but here is why, math-wise.

Let’s take Tom; he got his $100,000 mortgage 2 years ago at a rate of 5.49%. He was happy with the rate until he saw that True North Mortgage is now offering a rate of 3.29% on a 3 year term.

So why not break the mortgage and grab the new rate? Well, when Tom went to his current bank, he found out that his penalty to break his mortgage was a little more than anticipated. He thought he only had to pay 3 months of interest, he was wrong. He has to pay the Interest Rate Differential (IRD) penalty. This is very typical for all banks and trust companies.

Out of anger and frustration he asks the teller how she calculated the IRD penalty. After being told “the computer just does it” he spoke to the branch manager. The manager told Tom the following formula: Take your current rate and term remaining. In Tom’s case this is 5.49% and 3 years remaining. Look at your current lenders best rate (not posted) that matches your term remaining. In Tom’s case it is 3.49% on the 3 year term. Subtract this rate from your current rate and multiply by the years remaining on your term and your mortgage size. In Tom’s case 5.49% minus 3.49% is 2%. He needs to multiply 2% times 3 years and then multiply by $100,000 (his remaining mortgage balance). In Tom’s case his penalty is $6,000.

That’s a hefty penalty on a mortgage that is only $100,000 in size. But, Tom believes that True North Mortgage has such low rates that it can overcome his penalty. We like Tom, but he is mostly wrong. After we looked at how much he can save over the next 3 years, his remaining term, we determined that he would only be ahead $391 after the penalty is considered. Not a lot, and not really worth the effort. Furthermore, he would have to pay the penalty out of his own pocket or face legal refinancing costs.

So if you are like Tom and have a mortgage rate in the fives, just do nothing. Sometimes it doesn’t pay to try.