The Truth About Refinancing Your Mortgage
There are many resources available instructing home owners that when interest rates go down it is beneficial to refinance your mortgage. Unfortunately, not all of the facts are explained, and in many instances the lure of the lower interest rate and lower monthly payment while very attractive, can be quite deceiving.
One such resource is the online mortgage calculator. These calculators generally explain two things about your mortgage if you refinance. Firstly, how much you will save over the life of your mortgage, and secondly, how much you will save monthly.
One such calculator appeared on three different sites that claimed you could save over $78,0000 in interest on your $300,000 mortgage if you refinanced it from 6% to 4.25%. The payments were actually lowered by $283 a month. This appears to be an incredible savings until you look at all of the facts. A closer look will reveal that these calculators are very misleading. The calculator on all three sites asks you to input the penalty amount and closing costs that will be incurred when refinancing. Two of the sites go on to explain that these numbers are not used in the calculations and one fails to mention this fact completely.
When you sign your mortgage it is a contract for the term you select. The lender expects to get that rate of interest from you during the entire term. If you break the contract before the end of the term the bank will penalize you for any interest that they have lost. The greater of the Interest Rate Differential or three months interest is generally charged when you break your mortgage contract. The IRD is normally calculated by determining the difference between a lender’s posted rate at the time your mortgage was signed, and the lender’s posted rate for a term closest to the time remaining in your term. Lenders charge this penalty to ensure they are not losing money if you refinance your mortgage before the end of your term. Although this IRD calculation is common practice among lenders polices do vary. You should always contact your lender to get an exact penalty amount.
Another flaw with these online calculators and the numbers they project is that they are basing your interest saved on the full amortization of the mortgage. This is deceptive. In the example used above, you will still need to renegotiate your current 6% mortgage at the end of its term, just like you will still need to renegotiate the new 4.25% mortgage at the end of its term. These calculators assume that you will always renew at the same rate which is highly improbable. You will not save money refinancing your mortgage this way. If you have a need to lower your monthly mortgage payment you can do so by refinancing, but you will not come out ahead. You would be far better off consolidating your high interest debt during the refinancing of your mortgage. It is then possible to substantially lower your total cost of borrowing.
If you have equity in your home refinancing to pay off high interest debt could very well save you thousands of dollars. There are also plenty of advertisements showing that consolidating your debts can save you a great deal of money every month. Sounds like a good idea, right? Not so fast. Ensure your banker, or broker is fully explaining the savings found by refinancing. Work with a mortgage professional who can analyze your debt and take the current balances, interest rates and payments of all of your debts and project what your total debt will be in 3 or 5 years with your current mortgage. Compare this to refinancing and paying off all of your high interest debt. There are four options to look at:
1. Increase your monthly cash flow by having your current projected balance and your refinance balance the same after a 3 or 5 year term This will leave you with the same amount of debt, but a lower monthly payment.
2. Lower your total debt by keeping your monthly payment commitment the same with your mortgage and all other debt payments included. This will not free up any cash on a monthly basis but your interest savings at the end of your 3 or 5 year term will be significant.
3. A combination of increasing your monthly cash flow and reduction of the total amount owed at the end of the 5 year term. This will provide some instant gratification with lower monthly payments while reducing the total amount owed at the end of your term.
4. Extending your amortization period to the maximum 35 years to lower your monthly payment as much as possible. This should only be done when lower monthly payments are absolutely necessary as the interest costs will be significant.
Everyone has unique financial situations, short term and long term goals. Find a mortgage professional that you are comfortable with and fully explain your short term and long term goals. Your mortgage professional will be able to fully explain the outcome of refinancing your mortgage and find a mortgage that meets all of your needs. If you do not fully understand how your mortgage professional is arriving at any amounts ask him or her to explain in detail. If you still do not understand, ask again. Hopefully they are not using an online calculator.
New Mortgage Complete
We received the papers from the lawyer today for our mortgage refinance and worked with the numbers. I am pleased to say that the transaction cost us nothing. Actually, we saved about $933 over the remainder of our term including the penalty and legal fees. How is this possible you ask? Well the first factor was we locked a rate in after the first jump in fixed rates. By the time the deal closed fixed rates had jumped a bit more reducing our penalty. We would have done better if we would have locked in before the first increase but I am happy with the result. The second factor was that we were able to get our penalty reduced by $1168.48. This took a couple of phone calls and some explaining to our lawyer, but it in the end it was reduced. Check out the Original Discharge Statement and the Revised Discharge Statement. I removed the personal and lender information from the statements. I am curious to know what the asterisk represents internally to the lender. If you want to know how we saved this money, purchase my soon to be available ebook, The Mortgage Reduction Guide.
Saving money by changing lenders was a perk, but not the reason we chose to move our mortgage to National Bank. National Bank has an All in One Product that we felt would better suit our needs and save us some interest costs. I rarely recommend products on my blog, but this one impressed us so much that I believe it is worth mentioning.
In the next couple of weeks I will show you how we intend on saving money using this product and how you may be able to as well. Due to the structure of the account I am also going to have to change the way I track our Mortgage Pay Off Progress. I am bouncing a couple of things around, but I have not decided exactly how I will track this. I may add a line for Net Worth to the mix. I have updated it to reflect the new mortgage amount and interest paid. To properly reflect the cost of the switch I have included the penalty and the legal fees into the interest costs. These number will change quite a bit by June or July when we consolidate some accounts and no longer have money idly sitting around.
Original Balance: $316,000.00 (Jul 2008)
Current Balance: $238,836.86 (May 2010)
Total Payments: $108,907.77
Total Interest: $31,137.38
Projected Interest Saved: $270K +
Mortgage Questions
I have included a video that I think makes a very strong point. When you are dealing with a financial institution ask questions about the products you plan on using and get the answers in writing. This is applicable to all products but I will concentrate on mortgages.
When you are first buying a home it is very exciting and very stressful. You will deal with your mortgage rep and lawyer and you will likely run into things that you don’t quite understand. Ensure that you ask questions and have things explained to you until you do understand. Some common questions would be:
- Is the mortgage portable and assumable?
- What are the exact prepayment privileges? When can prepayments be made and how much?
- Can the mortgage contract be broken without selling the property?
- What is the penalty if the mortgage contract is broken and how is it calculated?
- Can you increase the payment amount and the payment frequency?
- If you are in a variable rate mortgage and want to lock in, what fixed rate do you receive? Posted less a certain percentage, or is it negotiated?
- If I take a cash back mortgage does the penalty increase and by how much?
- If you accept mortgage life and disability insurance can it be canceled at any time?
Ensure that you ask questions as not asking may cost you in the long run. Be wary of mortgages with very low rates. Many are “Value” or “No Frills” mortgages which offer little or no prepayments and you may not be able to break the mortgage contract unless you sell your property. These mortgages can be very restrictive.
I am still working on my ebook, The Mortgage Reduction Guide which will be a little more specific with some questions that may end up saving you hundreds, or thousands of dollars on your mortgage. Make sure you ask for ask for a real pony or be left disappointed and possibly with less cash in your pocket! I love that commercial.
Mortgage Update
After being backed up for a couple of weeks due to the sheer volume of applications National Bank has issued a commitment for our mortgage. We have sent in all of the documents and we are hoping that we will have the All In One Account in place by May 13th. When it is in place I will start tracking our finances a little differently. I will be tracking our mortgage debt, tax deductible debt for our rental expenses and net worth. Although I was focused on paying off our entire $316,000 mortgage in 5 years I may have been too focused and missing out on some other opportunities.
My spouse can buy back some of her pension. Retiring earlier is very inviting. I will continue to keep my RRSPs topped up and my spouse will contribute to a spousal RRSP as we prepare for me to move to 100% self employment in the future. We may even look at TFSAs. Unfortunately the prepayment privileges are a little restrictive compared to my original mortgage. A 10% lump some and up to double every payment will not allow me to fully pay off the mortgage by the end of the 3 year term. If we are ever in a position where we are having money idly sitting around we will discuss ways to use it. At the end of the term we will not have a fixed component to our All in One product and should be able to pay off the balance in a few months.
If you have ever Googled anything like, “pay off your mortgage sooner” or “save money on your mortgage” you have likely come across mortgage acceleration programs or money merge accounts. The premise of most of these systems is that you never have money idling sitting in a chequing or savings account. Your money is always offsetting interest on your debt. This is what we are going to do, but I will pass on any pricey software. This will work to our advantage because at any given time we have between $9,000 – $15,000 sitting in our bank accounts waiting to pay expenses. Our plan is to keep our line of credit with a balance of about $20,000 while the rate is under our mortgage portion interest rate. When prime goes up and our line of credit interest is higher than our mortgage interest we will keep our line of credit balance right around $0.
Switching to National Bank’s All in One product will save us on interest costs and give us the flexibility with our debt and finances. I am looking forward to it.
Total Debt Service Ratio 2009
With our taxes now complete, I have the opportunity to figure out exactly what our Total Debt Service Ratio was for 2009. First I want to define GDS (Gross Debt Service Ratio) and TDS (Total Debt Service Ratio).
The GDS is the maximum percentage of your gross income that is allocated to paying the costs of carrying your home. This ratio includes your principal and interest mortgage payment, property taxes, heating and/or condo fees. To qualify your monthly carrying costs cannot exceed 32% of your gross monthly income.
The TDS is the maximum percentage of your gross income that can be used to pay your GDS plus all other debts. This ratio includes everything from the GDS as well as any other loans, credit cards or lines of credit. To qualify it cannot exceed 40% of your gross monthly income.
I want to mention that these are guidelines only and those with good history of managing their credit are allowed to go as high at 44% TDS without considering GDS at all. Yes, if people are not carrying any other debt and have no other monthly obligations their housing costs can eat up 44% of their gross income. This is somewhat scary as someone wanting a $400K mortgage could qualify making just under $60K per year. If you want to read further click here for the CMHC Quick Reference Guide.
I take the attitude that if CMHC uses 44% at the maximum TDS then that is what we should attempt to achieve. For 2009 our TDS was 41%. Not bad, but why were we unable to achieve 44%? $5523 represents that 3% of our income that we did not use for housing costs. This means that we were short approximately $460 per month for mortgage payments. Could we have found that money? Of course we could have. Cut gym memberships, cut donations, cut eating out, cut new computer, cut new theater seating, cut vacations and take advantage of public transit more often. Making up this $460 per month would be very easy for us.
Although achievable, I don’t see cutting those “luxuries” as an option. We are making great progress paying down the mortgage and as long as we are able to stay on track we are not going to change our lifestyle.
I want to note that we are at 41% by choice. Although with our regular mortgage payment and prepayment averaged just over $5,900 per month we are not locked into this payment and we have no other monthly obligations. There would be considerable stress if we were locked into those payments.
When considering your mortgage options ensure that you are not over extending yourself.