In Canada, a 5-year mortgage contract term is very common. But is it still the best choice? While it used to be the easiest term to qualify for, especially for first time buyers, that all changed on Oct 17, 2016 when the Government changed the rules again. When applying for a mortgage, it is important to think about contact term and how to reduce the size of mortgage payout penalties if you have to break your term early.
The other day, I just completed the paperwork to help clients refinance their mortgage. They were almost 3 years into a 5-year fixed rate mortgage contract and financial circumstances had conspired such that they needed to access equity locked in their home to deal with some issues. To refinance, they had to break their existing mortgage contract early and incur a sizable payout penalty with their mortgage lender.
It is tough to predict your financial needs or challenges 3 or 4 years out, yet statistics easily point out that over 50% of mortgage holders renegotiate their mortgage every 3.5 years. So, putting some thought into selecting the correct mortgage term in the first place is a very worthwhile exercise. Things to consider might include: whether your marriage is stable or there is break-up potential; whether you might sell the property and not replace it; whether you have a propensity to rack up consumer debt on credit cards or credit lines; whether costly renovations are foreseeable (old furnace or tired roof?); upcoming university expenses for your kids; potential for job loss or relocation; how about re-marriage and merging homes, just to name a few. If that might be you and you are in a default 5-year contract, chances are that you too will fork out a payout penalty to break that agreement, as did my clients. And it’s worth knowing some banks, especially the BIG 5 in Canada, make a lot of money with their penalties.
Payout penalties usually include two parts: the first is the interest the lender would have collected from you to the end of the contract term but now won’t, less what they can earn when they “re-lend” the money; the second is the punitive part. While penalty-part 1 makes sense (keeps the lender financially whole), part 2 of the calculation can produce some nasty surprises especially if your mortgage is with one of the BIG 5 banks, who typically have a healthier drink at this trough than most other mortgage lenders.
Let’s look at a realistic example: say 3.5 years ago you borrowed $300K for a 5-year term at 2.79% interest, amortized over 25 years. At the end of 3.5 years (today) you decide to break the mortgage contract and refinance. Your BIG 5 lender will calculate a mortgage payout penalty in the order of $8800! If you had a PhD in finance, you could break this penalty into part 1 (foregone interest profit) at about $1800 and part 2, the punitive part, at $7000. So, your decision (or lack thereof) to go with a fixed rate 5-year term has cost you – in hindsight – at least $1800 in this example, and a further $7000 because your own retail bank also has a punitive penalty calculation, which you didn’t know about until now! With a different lender, part 2 of the penalty could have been zero.
So, the next time you need to get a new mortgage or to renew/refinance an existing one, 1) understand that there are big differences in how lenders calculate payout penalties in the event you do choose to break your mortgage term early ($1800 to $8800 range in the example) so ask questions and choose your lender carefully, and 2) pause and consider whether the default 5-year contract term is really a good choice for you – if there is any uncertainty in your future perhaps a 3 or 4 year term might be more appropriate. This information could save you a lot of money in the long run, and that is how to become mortgage-free faster.
Thinking about a new mortgage? Thinking about just walking into your local bank?