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The Mortgage Qualifying Rate (MQR)March 16, 2011
I’ve had a lot of calls lately from borrowers who are thinking about refinancing their mortgage, so I thought I’d write a summary to help my readers answer that question.
Today’s post will outline a step-by-step process and offer some suggestions where appropriate (this exercise should take you 30 minutes or less). Of course, if you prefer, you can call me instead, and we’ll walk through the analysis together over the phone.
Here are three key steps that will help you determine whether now is a good time to refinance.
- Calculate your mortgage penalty.
If you have a variable-rate mortgage, your lender will normally charge you three-months interest based on your current mortgage balance.
If your mortgage rate is fixed, your lender will charge you the greater of three-months interest or interest rate differential (IRD), also using your current mortgage balance.
The IRD formula is a little complicated, but I walk you through a detailed explanation of the different ways it is calculated in this post if you want to become an expert on the topic.
You can also use my penalty calculator as a shortcut. (Note: If your mortgage is with a Big Five bank, enter the posted rate that was offered at the time you obtained your mortgage in the “Current interest rate” field. Spoiler alert: This will substantially increase the size of your penalty.)
My calculator will give you a reasonable estimate, which is a good start, but you can also call your lender directly to get the exact amount.
Money Saving Suggestion: If you have cash/investments or a home-equity line-of-credit (HELOC) and you are planning to pay out your existing mortgage, you can make a prepayment to reduce your mortgage balance just prior to paying it off. (Lenders will typically allow you to make additional lump sum payments that are between 15% to 20% of your original mortgage balance each year.)
This will lower your mortgage balance (which is used to calculate your penalty), and you can recover those funds or roll the HELOC balance into your new mortgage in short order. Most borrowers don’t do this but it’s an easy way to reduce the size of your payout penalty.
- Compare your current rate to today’s rates.
Generally speaking, if you have a five-year fixed-rate mortgage at 3% or higher, or a variable-rate mortgage priced at prime or higher, a refinance is worth considering. In simple terms, you want the savings on what you are paying today to be greater than the cost of any penalty plus refinancing costs, such as legal fees, appraisals, etc. (A reasonable estimate for refinancing costs would be $1,200.)
Money Saving Suggestion: If your refinancing will leave you with a lower payment (which should be the case) consider paying your new mortgage at your old rate by scheduling an ongoing automatic additional prepayment. This will plough your saving back into the mortgage and accelerate the speed at which you repay it (more on this below).
3. Include any interest-rate saving realized by rolling in other debts.
If you have other debt, you can often roll that into your new mortgage as well (subject to qualification). Don’t forget to factor in these savings as well.
Refinancing high-interest debt into your mortgage can save you money and dramatically improve your cash flow, sometimes even in cases where breaking your existing mortgage involves a substantial payout penalty. My debt consolidation calculator will help you quantify your potential saving.
Money Saving Suggestion: For a refinance to make sense, it should both save you money and increase the amount of cash you have left in your pocket at the end of the month. As you undertake your refinance and before you get used to having the newly saved extra money around, consider putting some or all of it back into your mortgage.
Here is an example of how that would work.
Assume that you are refinancing into a new $300,000 mortgage at the current five-year variable rate of 2.45% using a 25-year amortization.
If you set your mortgage payments $83 higher by pretending that you are paying a current five-year fixed rate of 3% and if we assume that the variable rate remains constant over the next five years for the purposes of this example, you will have paid off a little more than $5,000 of extra principal by the time your renewal rolls around.
I realize that today’s post is fairly technical but if you use the calculators and tools I have provided, you should be able to work through the suggested steps. That said, if you’d rather have me take you through the process personally, just send me an email or call (416) 304-0100 and ask for Dave.
Instead of wondering whether you could be saving money and paying off your debts faster by undertaking a refinance, let’s put your current borrowing costs to the test and see what the numbers say.