Save Thousands in Interest by Refinancing During COVID-19
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What Does COVID-19 Have to Do With Interest Rates?
COVID-19 has negatively impacted many things, but one positive impact is for those getting new mortgages today or who have variable-rate mortgages. In general, when bad things are happening around the world, interest rates tend to go down. Events like 9/11, the credit crisis of 2008, Brexit, and COVID-19 are all examples of situations where interest rates subsequently fell 1% or more over a short period of time.
During trying times, money usually flocks to safety. Canada is a safe country to park money in and bonds are a safe asset class. Fixed mortgage rates are tied to bond yields, so when bonds fall, fixed rates also fall (to learn more about why this is, you can read my other 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 can’t reasonably go any lower without venturing into negative territory.
What Is Happening With Rates?
After dropping in March, followed by a spike, as spreads over top of the bond yield increased due to the COVID “risk premium,” rates are falling steadily, and opportunity is brewing. With low interest rates, it’s a good time to break an existing mortgage and pay the penalty to take advantage of the situation and get a lower rate. A lot of our clients are refinancing now, not only to potentially save money for the remainder of their term, but also to start a new mortgage term for, say, 5 years with a lower interest rate instead of renewing in a year or two when interest rates could be higher.
I 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%, so fixed rates should be closer to 1.9% – 2.2%, but most banks are closer to 2.49% right now for a 5-year fixed, or lower for an insured mortgage. COVID-19 spreads are decreasing, so we expect this will get closer to its normal spread band very soon. After this, we will either see rates flatten out or start to increase as we recover from COVID-19.
How Do You Know if It Makes Sense to Break the Mortgage?
Let’s say you have a $500,000 mortgage with 2 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’ll do the math and estimate this for you (but if you would like to learn more about how the banks calculate the penalties, you can read more here).
We then evaluate the amount of savings over the remainder of the term. In an ideal situation, the savings will exceed the penalty over the remainder of the term, up until your maturity date.
One important thing to note here that is often forgotten, is that if you take a new 5-year term, your renewal will not be in 2 years’ time, you will instead renew in 5 years. If you keep your current mortgage, you will have to renew in 2 years, and rates are unlikely to be as low as the rate we can get today during COVID-19. As a reference, check the bond yield chart here (select 1W or 1M to go back further into history) and you will see that over the past 10 years, bonds have never been this low.
What’s the Game Plan?
The plan is to prepare a file and have it ready for when interest rates bottom and then start rising. This allows us to hold a rate for up to 120 days and see where rates head. If rates continue to tick up, it’s likely time to pull the trigger and refinance. Also, rising rates will shrink the spread on the penalty cost for the IRD (Interest Rate Differential) penalties for fixed rate mortgages.
Some of our clients have been able to break their mortgage and pay a $10,000 penalty and have saved over $30,000 over the term of their mortgage.
In order to hold these rates, we need a fully built file with 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 posted rates being so great, breaking a 5-year fixed rate mortgage before the maturity will cost you 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 3 months interest). To learn more about whether you should choose a fixed rate or a variable rate, you can read our post here.
Let’s use some figures to illustrate this. With a $500,000 mortgage at 3.5% today and 2 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 so there are no out-of-pocket costs.
First, here is a look at the annual interest costs. This is assuming that interest rates in 2 years, at the renewal time, have normalized at 3.2%.
Another way to visualize this is to look at the total accumulation of interest over 5 years.
In most cases, payments can be lower if you would 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 5 years is $8,500 lower. This means that in this example, the borrower would be ahead $8,500 over 5 years by refinancing.
How Can You Prepare to Take Advantage of This Opportunity?
My team will need to collect some information and documentation to build a file so that once we do hit the low point with rates, we can send out all our applications. To do so, contact us at [email protected] or 604-229-5515 and one of my team will be happy to help get this process started for you.