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Rates Are Dropping and You Have a Fixed Rate Mortgage—What Do You Do Now?
November 5, 2024 | Posted by: Matt Broom-Hall
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If you have a fixed-rate mortgage, you might think you're locked in until the end of your term. But what if switching to a lower rate could save you thousands, even after paying penalties? In today’s market, some homeowners with higher fixed rates may benefit from exploring their options—especially if rates have dropped since their original mortgage term began.
Let’s break down how this works and look at specific scenarios to help you determine if breaking your fixed-rate mortgage could be the right financial move.
The Basics: Fixed Rate Mortgages and Penalties
A fixed-rate mortgage locks you into a set interest rate and monthly payment for a specific period, providing stability and predictability. But if interest rates drop significantly during your term, you could be missing out on savings.
Breaking a fixed-rate mortgage to switch to a lower rate will involve paying a penalty, which varies depending on your lender. Here’s where understanding your lender type—monoline lender vs. traditional bank—and their penalty calculations becomes essential.
Monoline Lenders vs. Banks: How Penalties Are Calculated
Monoline Lenders
Monoline lenders, such as First National, Strive Capital, and MCAP, specialize in mortgages and generally don’t offer other banking products. They often have lower rates than banks and can offer more competitive options for refinancing.
For monoline lenders, the penalty for breaking a fixed-rate mortgage is typically calculated using the Interest Rate Differential (IRD). Monoline lenders base their IRD on the difference between your current rate and the lender’s current rate for a term matching the remaining period on your mortgage.
Banks
Banks calculate IRD penalties differently, often using their posted rates, which are typically higher than the discounted rates offered to customers. This can lead to significantly higher penalties when breaking a fixed-rate mortgage with a bank compared to a monoline lender.
In summary:
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Monoline Lenders: IRD penalty based on the lender’s actual rates for remaining terms, leading to potentially lower penalties.
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Banks: IRD penalty often based on posted rates, which can inflate the penalty amount.
Scenario: Evaluating a 5-Year Fixed Rate Mortgage with 3 Years Left
Let’s look at a scenario to illustrate how breaking a fixed-rate mortgage could work in practice. Suppose you have:
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A 5-year fixed-rate mortgage with an initial principal of $500,000.
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An interest rate of 5.69% with 3 years remaining.
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A penalty of $3,000 to break the mortgage, which can be rolled into the new mortgage.
Current Rates for Comparison
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5-Year Fixed Rate (Insurable Transfer): 4.39%
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5-Year Variable Rate (Insured Transfer): Prime - 0.90%, which is currently 5.05% (based on Prime at 5.95%).
Calculating Monthly Payments and Savings
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Current Monthly Payment at 5.69%:
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Monthly Payment: Approximately $3,141
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Interest Paid Over 3 Years (Remaining Term): ~$49,125
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New Monthly Payment at 4.39% (if Refinanced):
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Monthly Payment: Approximately $2,759
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Interest Paid Over 3 Years at New Rate: ~$42,060
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Potential Savings Over the Remaining 3 Years
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Interest Savings: $49,125 (old rate) - $42,060 (new rate) = $7,065
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Penalty Cost: $3,000 (rolled into new mortgage)
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Net Savings: $7,065 - $3,000 = $4,065
In this scenario, by paying the penalty to break the mortgage and switching to the lower fixed rate, you could save $4,065 over the remaining 3 years.
Other Scenarios to Consider
If the 5-Year Variable Rate at Prime - 0.90% (currently 5.05%) is appealing, you could also explore a variable rate option, which may offer additional savings as rates potentially decrease. Keep in mind that variable rates fluctuate with the market, so this option is best suited for those comfortable with some payment variability.
Eligibility Criteria for This Strategy
Breaking a fixed-rate mortgage isn’t for everyone. To qualify, you should meet the following criteria:
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Mortgage Age: Your fixed-rate mortgage should be at least 1 year old.
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Good Standing: You should have no late payments on your mortgage.
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Current Interest Rate: Your current mortgage rate should be higher than 5%.
If you meet these criteria, this strategy could provide significant savings, even after accounting for penalties and potential legal fees.
How to Get Started
If you’re considering breaking your fixed-rate mortgage to take advantage of lower rates, follow these steps:
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Calculate Your Penalty: Reach out to your lender (or check your lender’s portal) to determine your penalty for breaking the mortgage. For monoline lenders, this should be a straightforward IRD calculation based on your lender’s actual rates for the remaining term.
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Reach Out to Me: Once you have your penalty information, contact me via email or book a call. I’ll review the numbers and perform calculations to see if switching makes financial sense for your unique situation. Together, we can assess potential savings and identify the best options based on the current rate environment.