Generally the first thing that people think of when it comes to mortgage features is rate. While it is an important feature, is it truly the most important feature?
Let’s look at the various features of mortgages and consider why they are all important.
Although it is a goal for most individuals to pay their mortgage off in full at some point, some people find it overwhelming when you are just starting out on a 25 year period. Mortgage lenders typically allow prepayments on their fixed and variable rate mortgages which can include lump sum prepayments or increasing your regular mortgage payment and are generally 15% to 20% of your original mortgage amount. Any prepayments are applied to principal and can greatly affect your mortgage.
Let’s look at what happens if we simply increase our monthly payments.
*Calculations are based off a $300,000 mortgage at a fixed rate of 2.99% with a 5-year term and 25 year amortization, compounded semi-annually. *
As you can see by increasing your monthly payments during this 5-year term, you are in turn paying off your principal at an accelerated pace. By increasing the monthly payments by 20%, the home owner would be mortgage-free 5 years and 8 months sooner.
As I like to tell my clients I know you are planning on staying in this home, but life happens. You cannot definitively know what the future holds. You might have a job transfer, marriage, divorce. It is important to understand what it will cost you to break your mortgage early if need be.
If you are in a variable rate mortgage, you know your penalty for breaking your mortgage early will be three months interest. If you have a fixed rate mortgage your penalty will be the greater of three months interest or the Interest Rate Differential (IRD). IRD is defined as the difference between your current rate and the current market rate (Ex. If you are 2 years into your 5 year term, your IRD would be the difference between your current rate and a 3 year term rate (aligning with the remaining three years of the mortgage term). Once the mortgage lender has the IRD, they crunch some numbers: they take the percentage difference, multiple it by your mortgage amount, then by how many months remain, and finally divide by 12.
This may not sound too bad, but it can be significant depending on how the IRD is calculated. The big banks typically calculate penalties using posted rates, while most consumers have “discounted rates”. There are also products where the lender will offer their lowest rates but pair that with the highest penalty.
Let us compare two mortgages for their penalties after being 2 years into a 5-year term mortgage.
*Calculations are based off a $200,000 mortgage at a fixed rate of 2.99% with a 5-year term and 25 year amortization, compounded semi-annually. *
As you can see the penalty can be costly if you break your mortgage term on a fixed rate with a large institution.
Many home owners are rate sensitive and are most interested in securing the best rate possible. Below I will look at how different interest will affect you.
*Calculations are based off a $300,000 mortgage with a 5-year term and 25 year amortization, compounded semi-annually. *
You can see the difference in payments from 3.09% to 2.79% is approximately $45.00 per month or $1.48 a day. You can’t even buy a coffee for that amount. When looking at it over 5 years it can look more significant as there would be $2,700 over the term of your mortgage. That is still lower than some of the penalties you would be paying if you were to break your mortgage early!
Obviously rate is a factor in your overall mortgage product, but make sure you understand all of the features!