Is now the time to break your mortgage?

Finance Minister Jim Flaherty may have pressured Manulife Financial to reverse its five-year mortgage rate cut, but he can’t mess with the trend. A handful of smaller lenders and even the Bank of Montreal are still offering five-year mortgages below 3 per cent.

The mortgage war is on.

That’s good news for new homeowners who enjoy the comfort and security of a long-term fixed rate, and homeowners in variable rate mortgages or fixed terms coming to an end.

Even banks with higher posted rates will be in the mood to negotiate, and if they don’t, there’s an army of lenders and mortgage brokers willing to take your business.

Cost of breaking a mortgage
If you are currently in a fixed-rate mortgage and want to break it to take advantage of lower rates, things can get complicated. Lenders offer long-term, locked-in rates with the intention of borrowing at lower rates during the course of the mortgage, and make their money on the difference. In bond trading pits it’s called the spread or juice.

In fairness, the extra cost for fixed rates gives the borrower security from rising rates during the term of the mortgage while the lender assumes the risk – and that’s why the bank will try to get its pound of flesh for taking that risk through penalties.

Penalties for breaking a mortgage differ depending on individual circumstances or the mood of the bank. As a guideline, most major banks provide mortgage breaking penalty (or the more polite, prepayment) calculators on their websites.

There are generally two ways to calculate the penalty: three months interest or the interest rate differential (IRD), but the bank will make you pay the larger amount.

Three months interest penalty
To calculate three months interest, multiply the remaining mortgage amount by the current annual interest rate expressed as a decimal point. For example, a rate of 5 per cent would be expressed as 0.05. The result tells you how much interest you pay in a year. To get the three-month rate, divide by four.

Assuming a remaining mortgage of $100,000 at 5 per cent, the penalty is $1,250.

Interest rate differential penalty
Determining the interest rate differential (IRD) is much more complicated and rigged in favour of the bank. For a general idea start with your current annual interest rate expressed as a decimal, (5-perccent as 0.05). From there subtract the posted rate on a similar mortgage for the duration of the term, less any discount the bank offers.

In other words, if you are three years into a five-year mortgage enter the posted rate on a two-year mortgage minus the discount the bank offers. We don’t know the discount so let’s say the current annual interest rate on a two-year mortgage rate is 3 per cent.

Under those circumstances the difference between your current rate and what you would pay if you renewed that day for the remainder of the original term is 2 per cent.

To calculate the IRD multiply the rate difference (2-per cent) by the remaining mortgage amount and multiply that by the number of months remaining on the term of your current mortgage. Divide that number by 12 months.

In this case it would be (0.02 x $100,000 x 24) divided by 12, resulting in a $4,000 penalty.

This is where the arbitrary part comes in. By boosting the discount, the bank can boost the penalty. A discount of 1 per cent, for example, would result in a penalty of $6,000.

The odds are in the house's favour
That’s a hefty upfront cost to try to save money, so it’s important to predetermine just how much you are going to save over the long term in a new mortgage.

A mortgage calculator can help determine whether the amount you would save exceeds the penalty, but banks hate losing money. In addition to the posted penalty, some banks charge a discharge fee of a few hundred dollars.

Be sure to ask about all associated fees and include them in the overall cost of breaking your mortgage.

In the end, it may be cheaper to stay in your existing mortgage.