Our friends over at Green Mortgage Team sent us this informative comparative to illustrate whether it’s worth considering refinancing your mortgage during these uncertain times. ~Ed
What does COVID-19 have to do with interest rates?
Despite the substantial negative impact of COVID-19 across many industries, the virus has had a positive impact on mortgages, specifically for people getting a new mortgage today and for people that were in an existing variable rate mortgage. In general, when bad things are happening around the world, this tends to push interest rates down. Events such as 9/11, the credit crisis of 2008, Brexit and COVID-19 are all examples of situations in which interest rates subsequently fell 1% or more over a short period of time.
During trying times, money usually will flock to safety. Canada is a safe country to park money, and bonds are a safe asset class. Fixed mortgage rates are tied to bond yields, which means when bonds fall, fixed rates fall (to learn more about why this is, you can read another blog post here). For variable rates, the Bank of Canada dropped a full 1.5% over a short period of time to stem the bleeding and is in a position where they cannot reasonably go any lower without venturing into negative territory.
What is happening with rates?
After dropping in March and then spiking back up as spreads over top of the bond yield increased due to the COVID-19 “risk premium”, rates have been steadily falling since then and opportunity is brewing. With low interest rates, it makes more and more sense to break an existing mortgage and pay the penalty to take advantage of getting a new lower rate today.
Our clients are refinancing not only because they may save money over the remainder of their current term, but because now they will have a new mortgage for, say, five years instead of renewing in a year or two when rates could be higher at the time.
We believe we are very close to the bottom of the market. Typically interest rates are priced at bonds + 1.5%-1.8%. Currently bonds are hovering around 0.4%, which means fixed rates should be closer to 1.9%-2.2%, but currently most banks are closer to 2.49% for a 5-year fixed, or lower for an insured mortgage. The COVID-19 spreads are decreasing and we expect this will get closer to its normal spread band very soon. Following this, we will either see rates flatten out or begin to increase as we recover through the pandemic.
How do you know if it makes sense to break the mortgage?
Let’s say that you have a $500,000 mortgage with two years left on the mortgage, at a rate of 3.5% interest. The first step is to establish what the penalty to break that mortgage is. Don’t worry, we will do the math and estimate this for you. If you would like to learn more about how the banks calculate the penalties, you can read more here.
We will then evaluate the amount of savings over the remainder of the term. In an ideal circumstance, the savings will exceed the penalty over the remainder of the term up until your maturity date.
One important item that is often forgotten is that if you take a new 5-year term, you will not be coming up for a renewal in two years time, you will instead renew in five years. If you kept your current mortgage you would have to renew in two years, and rates are unlikely to be as low as the rate we can get at the present moment during this pandemic. As a reference, we encourage you to view the bond yield chart here (select 1W or 1M to go back further into history). You will find that over the past ten years, bonds have never been this low.
What is the game plan?
Put yourself in the best position possible to take advantage of a refinance.
We recommend that you have your file prepared and ready for the point when rates hit bottom and then start rising. This will allow us to hold a rate for up to 120 days and see where rates go from there. If rates continue to go up, it will make more and more sense to pull the trigger and refinance. Moreover, rates going up will then shrink the spread on the penalty cost for the IRD (Interest Rate Differential) penalties for fixed rate mortgages.
Some of our clients have decided to break their mortgage and pay a $10,000 penalty, but will save over $30,000 over the term of their mortgage.
In order to be able to hold these rates, we will need a fully built file, including supporting documents, to get the approval.
Should you go variable or fixed?
There is a lot that goes into making the decision of going variable or fixed. However, with the discounts off of posted rates being so great, it will cost anyone who breaks their 5-year fixed rate mortgage before the maturity dearly. In my analysis, the penalties to break a 5-year fixed mortgage early are anywhere from 500%-1,000% more than if you break a variable mortgage (where the penalty is capped at three months interest). To learn more about whether you should choose a fixed rate or a variable rate, you can read more here.
Let’s use some figures to illustrate this. We will use the example of a $500,000 mortgage at an interest rate of 3.5% today, with two years left on the mortgage, compared to a new refinance at 2.29%. The mortgage penalty is added to the outstanding balance of the new mortgage, which means there are no out of pocket costs.
First, here is a look at the annual interest costs. This is assuming that interest rates in two years, when the renewal has come up, has normalized at 3.2%.
Another way to visualize this is to look at the total accumulation of interest over five years.
In most cases, the payments can be lower if you prefer a lower payment. If we keep the payments the same as the current mortgage, we can see that although the mortgage balance starts off higher due to adding the penalty to the outstanding balance, the mortgage outstanding balance after five years is $8,500 lower. This means that in this example, the borrower would be ahead by $8,500 over five years by refinancing.
How can you get prepared to take advantage of this opportunity?
Our team will be happy to help get this process started for you. We will need to collect the necessary information and documents to build your file, so that once we hit the low point with rates, we can send your application to the lender. To prepare yourself for this opportunity, contact us at GreenMortgageTeam.ca or 604-229-5515.