When shopping for a mortgage, it’s a given that people will try to find the lowest interest rate. However it’s not the only factor that determines how much the loan will cost you.
In fact, sometimes mortgages with lower rates have more restrictions on how quickly you can pay down the loan, as well as penalties for breaking the contract early.
Loans that charge you a fee for breaking the contract early are known as closed mortgages, and the fees for breaking a contract can be hefty, so you’ll want to be aware of all the conditions in your contract.
“The majority of Canadians that sign up for a five-year term actually break the contract in three years. So you need to not only look for the lowest rate, you’ll need to look for flexibility, too,” says Nalie Nguyen, executive director of Dash Mortgage in Calgary.
Flexibility in a mortgage: what to look for
Break or Prepayment Fees
A prepayment penalty is a fee for paying back your loan ahead of the predetermined schedule. If the terms of your loan include a prepayment penalty clause, then you’ll be penalized if you pay off your debt early. Typically, a prepayment penalty fee is the sum of three months interest on your mortgage but it can be much higher. To avoid an unpleasant surprise when you close out the loan, make sure you understand the terms of the fee in your contract.
The sooner you pay your mortgage, the less interest you pay over the length of your contract. The terms of early payment vary from lender to lender, but most closed mortgage products allow a once-per-year lump sum payment of up to 20% of the remaining principal amount or balance.
Adjustable payment schedules
Adjustable payment gives you the flexibility to change the amortization schedule, choosing from five different mortgage payment options: monthly, bi-weekly, accelerated bi-weekly, weekly, or accelerated weekly. With an accelerated weekly mortgage payment, you still make 52 payments per year, but the payment amount is slightly more than a regular weekly mortgage payment, allowing you to pay off the loan faster.
A portable mortgage can be transferred from one home to another. The biggest benefit of a portable mortgage is that you can secure a low interest rate, but you also don’t have the hassle of closing one mortgage and applying for another when you move.
“As a mortgage broker I look at where lenders are flexible: the customer service, the penalties, the options—all those combined. Then I work out the interest difference with the client, and ask, ‘Are you okay paying a higher interest rate but you have more flexibility?’ Nine out of ten people actually go with more flexibility,” says Nguyen.
Finding the right mortgage
Finding the right mortgage really does depend on your specific circumstances — not just financial, but also market conditions and your projected life plans over the length of the contract’s term. The vast majority of Canadians opt for a five-year term, but a lot can happen in five years. You’ll want to consider:
- Your job security and future earning potential
- Possible changes in family or marriage
- How happy you are with the property
- How quickly you want to pay off the mortgage
- Predicted changes to mortgage rates
- Preferred payment options
- Potential payout penalties
How break fees can hurt your wallet
Let’s say a couple purchased a home with a closed mortgage of $250,000 on a five-year term, with an interest rate of 2.5%. There was another option, however — a portable mortgage which would allow them to carry over the loan to a new property. But the rate was 2.7%, so the couple went with their first choice.
The difference between the two rates, in interest saved: $479.94.
After two years, however, the couple has a young family and wishes to move into a bigger house. Because they are in a fixed mortgage, there’s a penalty, or break fee.
Break fees can vary, but are often either the sum of three months of your mortgage interest or the interest rate differential (IRD), whichever is greater. (The IRD is a formula that calculates the difference between what you would have paid in interest and the bank’s current rates, for the rest of your term).
In this example, the break fee is based on three month’s interest: $495.921.
In effect, the lower rate has had no impact on your savings if you decided to cancel your mortgage early. That's why sometimes, it literally pays to go for flexibility over a lower rate.