You may be tempted to refinance your mortgage given that the rates have hit rock bottom. But, should you? The answer would be yes in most cases, but not all.
Meanwhile, high vaccination rates are boosting economic recovery. The time will soon be ripe for the Bank of Canada to raise the interest rate.
If you’re considering refinancing a mortgage, now is an excellent time. You should first, however, see if this exercise will be worth your while. MoneyWizard will provide you with the information you need to make a smart decision.
What is Refinancing?
Refinancing involves paying off the current lender with loan proceeds received from another lender. You would normally consider a mortgage refinance when a lender offers significantly better terms that can reduce your overall financing cost.
Refinancing activity revs up during a period of falling interest rates, and that’s precisely what’s happening right now. A declining interest rate allows borrowers to seek financing from another lender at a lower interest rate than what their current lender charges. Depending on their present loan’s interest rate, refinancing could translate to significant savings.
Lower interest rates aren’t the only reason for refinancing, though.
Why Refinance?
The first thought that pops up when someone hears the term ‘refinancing’ is a lower interest rate. However, refinancing has several use cases.
Lowering your rate
A lower interest rate is the most common reason for refinancing a mortgage. Since the interest rates have been in a downtrend for some time, it may be worthwhile to consider your refinancing options with another lender.
In addition to interest rates, you may be able to sweeten the deal further with the new lender if you’ve paid down a good portion of the principal on the original loan. A lower principal reduces the Loan to Value (LVR) of the new loan. A lower LTR means the lender will perceive your loan as relatively low risk and offer a better interest rate.
The reduction in rate as a result of refinancing should be significant enough to at least cover the refinancing costs. A reduction of 0.5% may be significant if a mortgage still has a 15-year term remaining, but not so great the term only has 3 years left. Plus, you’ll also need to consider the total refinancing costs, outstanding principal, and how long you plan on living in your current home.
Refinancing to consolidate debt
If you have borrowed from multiple sources, it makes sense to consolidate these debts into your mortgage to minimize your interest expense. While on surface, this looks like a smart move, there’s more to consider.
When you consolidate unsecured debts such as your credit card balances into a secured debt such as your mortgage, you run the risk of a foreclosure on default. If you don’t pay off your credit card balances, it only puts a dent in your credit score. The consequences of foreclosure, though, are much direr; you can end up losing your home.
Consolidating debts makes a lot of sense for someone confident about being able to pay off the dues on the consolidated loan. The post-consolidation APR can result in significant savings in the total interest expense.
Accessing equity in your home
Over time, as you accumulate enough equity in the property, you’ll be able to use cash-out refinancing to access the accumulated equity. A cash-out refinancing gives you access to additional funds because you can borrow an amount greater than the current loan’s outstanding principal, pay off the old loan, and keep the difference.
There are two caveats you need to keep in mind with cash-out financing. First, your APR will likely be higher on the new loan since your LTV will increase. Second, you can access only 80%–90% of your home equity, not 100%.
For instance, assume that your home is valued at $500,000 and you have $300,000 outstanding on your mortgage. You can refinance the current loan with a new $400,000 loan, pay off the $300,000 outstanding on the old loan, and keep the $100,000. You can use the $100,000 for paying off high APR debts such as credit card debt or student loans.
Costs of Refinancing
Borrowers often forget to account for all refinancing costs when they calculate the savings from a lower interest rate. Following are the fees you should factor into your calculations while assessing the feasibility of refinancing your mortgage.
Mortgage Prepayment Penalty
When a borrower pays off the mortgage before the end of its term, the lender may charge a prepayment penalty. Most mortgage agreements have a provision for prepayment penalties, and you should check your agreement to look for this provision as you calculate your refinancing costs.
Generally, the prepayment penalty on a mortgage is greater of:
- Interest for three months computed based on the loan’s current outstanding amount, or
- The interest rate differential applied to the outstanding loan amount for the remaining term of the loan.
For instance, let’s say you have $100,000 outstanding on your mortgage that charges a 3% APR. The mortgage term has 36 months remaining, and the lender charges 2.65% APR on new loans.
- Interest for three months:
$100,000*3%*312=$750
- The interest rate differential (i.e., the difference between the APR of your loan and the currently prevailing APR) of 0.35% applied to $100,000 for 36 months:
$100,000*0.35%*3612=$1,050
In this example, you’ll pay $1,050 (i.e., higher of the two) as a prepayment penalty.
Mortgage Discharge and Registration Fees
Your current lender will charge a discharge fee if your new loan is from another lender. When you pay a lender in full, the lender will need to relinquish the right to your property. This requires the lender to let the territorial land title registry office know that the mortgage has been paid in full and your property is free from charge.
The fees vary across lenders and provinces, but typically you’ll pay anywhere between $200–$375. If your lender is federally regulated, you could refer to the mortgage contract to look for the discharge fee. If you don’t see it there, you may contact FCAC and file a complaint.
While a discharge fee is only charged when your new loan is from another lender, you’ll always pay a registration fee when refinancing. The fee is charged because the lender has to deregister the current mortgage amount and re-register the new mortgage amount on your property’s title. Your provincial government decides the registration fee, but it is usually around $70.
Is Now a Good Time to Refinance?
The pandemic may have compelled you to reassess your financial position. Job losses, salary cuts, and reduced revenues have led people into thinking about ways to cut back on expenses wherever possible. In a slow economy, interest rates present a unique opportunity, especially for homeowners who had taken out a mortgage loan when the interest rates were high.
Interest Rates Remain Near Historical Lows
Interest rates bottomed out in April 2021 and have marginally increased since. As the vaccination rates rise and the economy recovers, the interest rates are likely to increase moving forward.
For now, though, they remain at their historical lows. This allows homeowners to refinance their mortgage with a new lender who can offer a lower interest rate. If you have an ongoing mortgage on your home, you may consider refinancing as an option.
Refinancing in a low-interest-rate environment is mostly, though not always, a good choice. You must look at your specific case and assess the costs before you make a decision.
Will the savings be enough to make refinancing worthwhile?
Refinancing is a great option to save up on interest, but it comes with a cost. Before you decide to refinance, do a cost-benefit analysis to see if your savings exceed the costs of refinancing.
If your mortgage loan’s term has almost ended, the savings from refinancing may not be enough to cover the refinancing costs. For instance, assume that you’ve taken a 30-year mortgage for $300,000 at a fixed interest rate of 4%. Your monthly payment will be $1,426.56.
Since the interest rates have fallen to 3%, refinancing will reduce your monthly payments to $1,261.81. You’ll end up saving $164.75 each month, or $1,977 annually. Let’s assume the total refinancing costs add up to $6,000.
You can compute the break-even point to understand how long your mortgage term must be for you to benefit from refinancing.
Breakeven Point=Total Refinancing CostsTotal Annual Savings from Refinancing
This formula gives you the breakeven point as the number of years it will take for the savings and costs of refinancing to equalize. In our example, the breakeven point is ~3 years [$6,000 ÷ $1,977]. If you have less than 36 months left on your mortgage term, you’ll lose money by refinancing the mortgage.
Some people also consider refinancing when they want to make their monthly payments smaller. This requires you to extend the loan term, which may increase your total interest expense even with a lower interest rate.
Mortgage loans have front-loaded interest payments, i.e., the portion of your monthly payment that goes towards interest is larger towards the beginning of the term and reduces over time. If you have 5 years left on a loan, and you refinance to a 10-year loan, your total interest expense will increase significantly even with a lower interest rate.
Another important consideration is how long you plan to stay in your current home, speaking of which…
How long do you plan to stay?
If you expect your family to grow in the near future or plan on moving to a better neighborhood, reconsider your refinancing decision. If you sell the house soon after refinancing your mortgage, you may end up with less money than if you had continued with the previous lender.
As calculated in the previous example, you have a 3-year breakeven point on your refinancing option. If you sell the house after year 2, your refinancing costs—prepayment penalty, discharge fees, and registration fees—will exceed your total savings from refinancing.
Essentially, two factors drive your refinancing decision; refinancing costs and the interest rate. The more the refinancing cost, the longer you’ll need to stay put in your home to break even. The bigger the reduction in interest rate, the sooner you will break even.
Frequently Asked Questions
How long does it take to refinance a house?
Most lenders will process a mortgage refinance within 30–45 days. When a lender has a lot of loan applications, like during times of falling interest rates, it could take a little longer than 45 days. In this case, it’s a good idea to lock in your rate with the lender. Interest rates can change overnight, and you don’t want to be stuck with a higher APR simply because the lender took more time to process the application.
Does refinancing hurt your credit?
Refinancing your mortgage has many benefits, but it could put a dent in your credit score, at least for a short while. When you apply for a mortgage refinance, your new lender will conduct a hard credit pull to assess your creditworthiness. This hard pull will affect your credit score for one year, and appear on your credit report for two years. Several other factors related to refinancing also affect your credit score. For instance, refinancing will shorten the age of your credit account, and this could also hurt your credit score.
