A couple of weeks ago, the Bank of Canada surprised the market by cutting interest rates a quarter of a percent, setting the overnight rate at 0.75%. In response, Canada’s banks sat on their hands for a while and then begrudgingly cut prime from 3% to 2.85%, and only after Royal Bank was the first to do so. Banks: they’re bigger lemmings than the average high school student.
Here are a few more words I had to say about the surprise interest rate cut.
If you hold a variable rate mortgage, everything is coming up you. It depends on the mortgage contract, but for the most part your payment is going to stay steady throughout the 5-year term. That means less interest paid every year and more money going towards principal. That’s good news for borrowers, but bad news for banks.
But what about the 2/3rds(ish) of Canadians that are currently paying off a fixed rate mortgage? 5-year rates have crept down to as low as 2.69%, while some sucker like you is paying 3.49% or even 3.89%. Hell, remember when some moron told you to lock in a 3.89% 10-year fixed mortgage?
Yeah. Not my finest moment. Although I still have a few years to redeem myself on that one.
In ‘Murica, things are a little different than in Canada. They lock in their mortgages for 15 or 30 years, which is a pretty dope system from the homeowner’s perspective. For a little extra in interest (current U.S. rates are ~3.8% for a 30-year fixed), you can lock in your payments for most of your adult life. This pretty much ensures a situation where the actual value of your mortgage payments will continue to do down over time due to inflation.
Because terms are so long in the U.S., the option exists t0 refinance your mortgage. Sure, there are fees attached to doing this, but generally the long-term interest savings more than make up for any short-term fees that are paid. A 1% discount in a mortgage rate can add up to tens of thousands in mortgage savings over the life of a 30-year loan. Unfortunately, Canadian loans aren’t quite that simple.
I know a couple who signed up for a mortgage worth 6.5% annually back in 2008. 2010 rolled around and they were looking to get some sweet refinancing action going on. I believe they were in the market for a 3.49% fixed, which represented interest savings of nearly $10,000 annually on their $300,000 mortgage. Everything was rolling along until they asked the original lender to calculate the payout penalty.
The payout penalty came in at more than $20,000. Like most people, they didn’t have the cash to come up with the penalty, and there wasn’t enough equity in the house to borrow against it to come up with the cash either. So they they were stuck paying 6.5% for an additional 3 years.
Hidden in the fine print of your mortgage are the penalties incurred if you pay it out early. There are two, essentially, which cost you either three months worth of interest or the interest rate differential (or IRD for short, because like hell I’m typing that out again), whichever is greater.
Uh, Nelson, WTF is the IRD? Also I G2G so TTYL.
For the love of God, stop talking like that. Everyone.
The IRD is the difference between the rate you’re paying now and the lender’s current product for the life of the remaining mortgage. In the example above, the 6.5% rate would be compared to the 3-year rate currently offered by the bank. If the same 3% spread existed between the original lender’s products, you’d be looking at a penalty of 9% of the mortgage balance, since each year is calculated.
Let’s put that in number form:
Current rate: 6.5%
New rate: 3.5%
Years left: 3
Total penalty (6.5%-3.5%) x (number of years) x (amount owing) = penalty
Banks are also allowed to use their posted rate at the time of giving you a mortgage in the calculations. Say the couple above was smart when getting their mortgage and didn’t take the first offer. Instead, they negotiated it down to 5% annually. The original mortgage would have looked something like this:
Mortgage rate: 6.5%
Net rate: 5%
Even though the rate above is 5%, the bank can use 6.5% as the basis for calculating IRD. That way, they can really sock it to a borrower. And yes, this is fully legal. It’s hidden in the fine print on page 12 of the mortgage contract I guarantee you didn’t read.
So as rates have gone down, Canadians have largely been shut out of that sweet refinancing game. But not all is lost. There’s one really easy way you can refinance. The problems is it just doesn’t come along very often.
When your term is due, your lender will send you a statement to try and sign you up for another 1-5 years, depending on what you choose. At that point, you’re free to go to another lender and try your luck with them without paying a penalty.
The banks will generally send out a renewal offer with pretty crummy rates, because they’ve crunched the numbers and know that something like 80% of Canadians will just sign back up without even checking what’s out there. It’s the low-hanging fruit of the banking world, and it’s really profitable. You can blame them for trying.
If that happens to you, you can either take the impetus and go to another lender or give the bank a call and see if they’ll give you a discounted rate. They’ll usually say yes, and then it’s up to you to determine just how good that rate is when looking at other lenders.
As a Canadian borrower, it’s still possible to refinance your mortgage. It’s just a little tougher to do it on this side of the border than it is down south.