Is Breaking Your Mortgage for a Lower Rate Worth the Prepayment Penalty?

Is Breaking Your Mortgage for a Lower Rate Worth the Prepayment Penalty?

As interest rates fluctuate, homeowners often consider breaking their current mortgage to secure a lower rate. However, doing so can come with a significant cost: the prepayment penalty. This fee is designed to compensate lenders for lost interest and is often calculated using either three months’ interest or the Interest Rate Differential (IRD), which can vary widely.

Key Considerations Before Breaking Your Mortgage

1. Prepayment Penalty: The primary hurdle in breaking a mortgage is the prepayment penalty. For variable-rate mortgages, it’s typically a straightforward three months’ interest. However, fixed-rate mortgages may involve a more complex Interest Rate Differential (IRD), which can result in a much higher penalty, depending on the difference between your current rate and the lender’s posted rate.

Example: If you locked in a 5-year fixed mortgage a couple of years ago at a higher rate and rates have dropped significantly, the IRD can be quite large. You need to calculate how much the penalty would be before determining if breaking the mortgage is financially beneficial.

Let’s say you have a $400,000 mortgage at a 3.5% fixed rate with two years remaining. If the current posted rate is 1.5%, the IRD will be calculated based on that 2% difference. If your lender charges $10,000 as a penalty, you must determine if the savings outweigh that cost.

2. Savings from a Lower Rate: If you’re breaking your mortgage to obtain a lower interest rate, you must weigh potential savings against the prepayment penalty. While a lower rate can save you money on monthly payments and interest over the remaining term, those savings need to exceed the penalty to make it worthwhile.

Example:

Imagine you could refinance from a 4.0% rate to 2.5%. On a $500,000 mortgage, this could save you $400 per month, or $9,600 over two years. If your penalty is $7,500, you’d save $2,100 overall. However, if your penalty is $12,000, you’d end up losing money.

3. Remaining Mortgage Term: The length of time left on your mortgage plays a crucial role. If you’re near the end of your mortgage term, the prepayment penalty may be less impactful, making it more worthwhile to break the mortgage for a lower rate. Conversely, if you’re just a couple of years into a 5-year term, the penalty could be prohibitively expensive.

4. Market Outlook and Rate Trends: Consider the likelihood of interest rates dropping further or rising again. If rates are expected to continue falling, it might be worth holding off on breaking your mortgage to wait for even lower rates. Conversely, if rates are predicted to rise soon, locking in a lower rate now might outweigh the penalty.

5. Other Factors: Besides the financial implications, there are other considerations. If you plan to move or sell your home in the near future, breaking your mortgage for a lower rate might not make sense, as the penalty would still apply, and you’d have less time to recoup your savings.

How to Calculate If It’s Worth It

Breaking your mortgage requires careful calculations:

• Estimate the Prepayment Penalty: Contact your lender to find out the exact penalty. Some lenders may even provide a breakdown of how it’s calculated.

• Compare the New Rate: Look at the difference between your current rate and the new rate you could secure.

• Project Your Savings: Estimate how much you would save in interest and monthly payments with the new rate over the remaining term.

• Account for Fees: In addition to the prepayment penalty, there could be other fees involved, such as administrative costs or legal fees. Include these in your calculation.

Conclusion

Breaking your mortgage for a lower rate can be a smart financial move, but it requires a careful analysis of the prepayment penalty, your potential savings, and the remaining term of your mortgage. For some, the savings might not justify the penalty, while others could benefit from a lower rate in the long run. Always consult with your mortgage lender or a financial advisor to make the best decision for your unique situation.

If you’re thinking about breaking your mortgage, reach out for a personalized assessment to help you decide whether it’s the right move for you!