To Refinance or Not to Refinance?

It’s true, the Bank of Canada has cut interest rates, and banks in turn are offering lower interest rates as well. So you wouldn’t be the first to consider refinancing your mortgage. But does it make sense for your particular situation?

To back up a bit, the term 'refinancing' essentially refers to the replacing your existing debt obligation with another made up of different terms. When it comes to mortgages, this can refer to a different debt amount - such as when you roll outside debts, like credit cards and personal loans, into your mortgage - or it can refer to a different interest rate.

Renewal vs. Refinance

A mortgage renewal allows you to change mortgage providers or interest rates at the end of a previously agreed-upon term. In Canada, these typically occur in one-, two-, five- or ten-year increments.

A refinance, on the other hand, often comes with a penalty. To get out of your existing mortgage, you usually have to pay a fee - typically equivalent to three months interest or the interest rate differential (IRD), whichever is greater.

The IRD is the difference between the interest rate you agreed to pay the lender at the beginning of your term, and the rate at which they can lend that money out now. Given that interest rates are at historic lows right now, chances are this number is going to be greater than three months' interest.

Doing the Math

To find out if refinancing is the right decision for you, you have to do a little math. By factoring in the amount of months you have left in your existing term, the amount of money you'll be saving if you refinance, and the cost of the penalty, you'll be able to figure out if refinancing makes sense for you.

The calculations can get tricky, as Patricia Lovett-Reid, VP of TD Waterhouse Canada, reveals. She offers the example of an individual who would like to refinance $100,000 outstanding on a locked-in fixed rate mortgage at 6% interest. With 45 months left on the term, the individual wants to refinance at 4.4%.

With a potential interest rate savings of 1.6%, Lovett-Reid calculates that three months' interest would equate to $1,500 and the IRD would be $6,000 - so, taking the higher of the two, the lender would charge a $6,000 penalty for the individual to get out of the mortgage.

If the individual chose to lock into a four year term, financing the new sum - $106,000 - at 4.4%, the savings would only be $5,176. Definitely not worth the time and hassle of the refinance.

Other Obstacles

You might not be able to refinance if your current mortgage is for more than 90% of your home’s current market value. You can't refinance if you have less than 10% of equity built up in your home. So if you put less than 10% down when you purchased your home, or if your home’s value has dropped considerably (like so many others in the country), refinancing may not be an option for you. 

A Strong Credit Score Helps

Like original purchases, refinances also require a strong credit score. If you've let your credit score slip in past years, or if you've run into financial difficulty, you could be declined for a refinance. Lenders have steadily ratcheted up their requirements in a credit score, so while a 680 may have been good enough a year ago, for instance, it won’t get you the best available rate today.

You're not alone if you think making the decision to refinance is a complicated one. Your best bet is to contact your bank representative or mortgage broker to find out if you are a candidate and, if so, what your potential savings might be.