Does it make sense to break your mortgage in 2021?

Record-low mortgage rates have made it increasingly attractive to refinance your mortgage at a lower rate, but when does it make sense? Mortgages come in different types, either open or closed, and variable or fixed. The specific type of your current mortgage will impact the costs associated with refinancing your mortgage, which can be more than any potential interest savings.

An open mortgage allows you to pay off or refinance your mortgage without any penalties. This means that you can easily refinance into a lower rate at any time. Although open mortgages are the most flexible option, they have higher mortgage rates than closed mortgages.

Closed mortgages are the most common type of mortgage found in Canada, and they have lower rates than open mortgages. With a closed mortgage, paying off your mortgage early or refinancing will mean that you will have to pay prepayment penalties.

These mortgage prepayment penalties can vary from a few thousand dollars to tens of thousands of dollars depending on the type of rate your mortgage has. Variable rate mortgages usually have lower prepayment penalties, often just three months’ worth of interest.

Penalties for fixed rate mortgages can be considerable, as it is the greater of three months worth of interest or the Interest Rate Differential (IRD). The IRD is the difference in interest that you owe to your lender for the remainder of your mortgage contract, calculated at the two different rates, your original rate and the current rate. For some banks and financial institutions, the IRD may be calculated at the bank’s posted rate, minus your original rate discount, which can mean that the IRD can be quite significant.

Knowing what type of mortgage you hold will let you understand the possible penalties that come with breaking your mortgage, but at what point would any potential interest savings outweigh the costs of mortgage penalties? It depends not only on your outlook on future interest rates but also your mortgage’s original rate compared to the current going rate.

The best mortgage rate in Canada as of January 2021 is 1.33% for a five-year fixed rate mortgage. Let’s consider a $500,000 mortgage with a five-year fixed rate mortgage at 3%. The mortgage was signed exactly one year ago in January 2020, so there are four years left in the mortgage, and the monthly mortgage payments are $2,000.

While a 1.67% drop in the interest rate from 3% to 1.33% seems small, it equals to a 44% decrease in the interest rate. If you were to continue with a 3% rate for the next four years, you will pay $57,422 in interest. If you switch to a 1.33% rate, the next four years would cost only $23,753 in interest. Your monthly payment will also decrease from $2,000 to $1,880, and you will make an extra $27,947 in payments towards your mortgage principal balance.

Even though you will be paying over $33,000 less in interest over the next four years, you will not save the entire amount. This is where mortgage break penalties come into play, and with four years left in your fixed term, the mortgage penalty will be around $27,000. This shaves off your total savings, making your four-year savings at $6,500. Saving $6,500 is nothing to sneeze at, and it can be put into use such as paying off credit card debt or even taking a few extra vacations.

How much time you have left in your mortgage matters too. If you only have two years left in a five-year fixed mortgage, you would save $3,400, from $17,000 in interest savings minus a $13,600 penalty.

In the event that a variable rate mortgage signed one year ago results in a rate of 3%, with current five-year variable rates in Canada being as low as 1.25% as of January 2021, your savings will be even greater. You will save $35,000 in interest over the next four years, and with a mortgage penalty only being three months’ worth of interest, a penalty of just $3,750 will give you total savings of over $31,000.

Mortgage rates significantly fell in 2020, and they can be expected to stay below 2019 levels throughout at least the rest of 2021. While rates will surely rise in the future, the key question is when. Whether that means you should refinance now if you are nearing the end of your term or holding off if you just entered your term, it depends on your current situation. Using a mortgage refinance calculator can help you see how much you will save if you break your mortgage, or in some cases, how much you will lose.