Break the mortgage before debt breaks you
From Tuesday’s Globe and Mail
PublishedMonday, Nov. 28, 2011 6:45PM EST
Last updatedWednesday, Nov. 30, 2011 2:26PM EST
Debt junkies, here’s how to break your borrowing habit by breaking your mortgage.
Warning: This will take discipline. If you follow this plan, you’ll commit yourself to a major debt paydown that will leave you little or no room to pay for new stuff on credit. But your mortgage will be paid off sooner, and you’ll get out from under that never-ending credit card or line of credit debt.
Let’s start with the breaking the mortgage part. Mortgage broker John Cocomile says you need to have a fixed-rate mortgage at a rate of at least 4 to 4.5 per cent to make a refinancing worthwhile. Also, you want to have debts to roll into your new mortgage.
The rationale for this starts with the fact that a penalty applies when you break a mortgage contract. For fixed-rate mortgages, the penalty is the larger of three months’ interest or what’s known as the interest rate differential (IRD). That’s basically the difference between your existing rate and current mortgage rates.
Mr. Cocomile said today’s low mortgage rates mean IRDs can be steep. So much so, in fact, that he questions the value of breaking a mortgage unless you do it as part of a larger debt consolidation.
“If there’s no other debt, the argument for breaking a mortgage is not really that compelling,” he said.
Let’s look at a real-life example based on one of Mr. Cocomile’s clients. This person owed $30,000 on an unsecured line of credit with a rate of 6 per cent and $19,000 on a credit card with a very low introductory rate that expires next month. The mortgage to be refinanced was three years into a five-year term, it had a rate of 4.5 per cent and there was a balance of $240,000.
Breaking the existing mortgage cost about $4,500 in penalties, an amount that was thrown into the new mortgage along with the line of credit and credit card debts. The client ended up with a new $295,000 mortgage at 3.09 per cent for four years.
The easy option for Mr. Cocomile’s client would have been to keep the 22-year amortization of the old mortgage. That would have kept payments low, but it wouldn’t have helped get the mortgage paid off as efficiently as it could be.
So here’s what Mr. Cocomile did. He took the total amount of monthly payments the client was making on various debts before the refinancing and made that the new mortgage payment. The amount of the payment is $2,330, which breaks down as $1,430 for the mortgage, plus $900 for the line of credit (it required a minimum monthly payment of 3 per cent of the outstanding balance).
Now for the payoff from this refinancing strategy: The new and larger mortgage will be paid off in 13 years, compared to the original 22 years. A subsidiary benefit is that the client gets to lock in a new mortgage at today’s ultra-low levels. The question is, what mortgage rate is best right now?
Up until recently, the slam-dunk move was to use a variable rate. These mortgages are pegged to the prime rate, now at 3 per cent, and discounts of 0.75 per cent were common. Now, the best discount around on variable-rate mortgages is 0.2 of a percentage point, and no discount at all off the prime rate is reality at some lenders.
Mr. Cocomile said there’s good value in three- and four-year fixed rates today. Both terms actually carry the same rate at some lenders right now, which suggests there’s little reason not to take a four-year term.
As an aside, Mr. Cocomile pointed out that attractive three- and four-year rates actually work against people who want to refinance. The lower these rates are, the bigger the interest rate differential that someone breaking a mortgage must pay.
There’s more to breaking your borrowing habit than breaking your mortgage, of course. A large amount of your cash flow will be sucked up by debt repayment, but you could still, in theory, use credit cards or a credit line to buy more stuff and ratchet your debt higher again.
So consider a borrowing holiday while you’re paying off your refinanced mortgage. Forget about your line of credit and cut up your credit cards, freeze them in a block of ice or stick them in a drawer. Mr. Cocomile’s advice to debt junkies who can’t break the habit but plan to refinance their mortgage, anyway: “Don’t bother – it’s not worth it.”
Here’s a plan for refinancing your mortgage, adding in your other debts and paying everything off sooner and at lower cost. This is a real-life example based on a client of mortgage broker John Cocomile.
Client’s Debt Profile
Mortgage with $240,000 owing at 4.5 per cent
Unsecured line of credit with a $30,000 balance at 6 per cent
$19,000 owing on a credit card with a low introductory rate of 1.99 per cent that rises to normal levels next month
Break the mortgage and fold the credit line and credit card debts into a new mortgage.
A $295,000 mortgage at 3.09 per cent for four years (includes a $4,500 mortgage breakage penalty)
Old mortgage payment: $1,430 a month
New mortgage payment: $2,330 a month
Old mortgage amortization: 22 years
New mortgage amortization: 13 years
Old mortgage renewal: November, 2013
New mortgage renewal: November, 2015
Estimated interest savings: $14,396 over two years (based on lowering the mortgage rate and saving on debt carrying costs for the credit card and credit line)