Refinancing a mortgage is a way for borrowers to get a lower mortgage rate, to lock-in a current rate, or to borrow money using their home equity. There are costs to refinancing a mortgage, which means that there will be times when it won’t make sense to refinance, but it can be a powerful tool to use for some scenarios.
When Should You Refinance?
Guiding through a mortgage refinance to see whether or not it is right for you would depend on how much you plan to borrow, what you are borrowing for, and the cost of refinancing. The two main reasons that borrowers refinance is to change their rate or to change their borrowing amount.
Lower Mortgage Rates
74% of mortgages in Canada have a fixed rate, which means that they won’t benefit from any decreases in interest rates before their term is over, unless they refinance early. Refinancing lets you renegotiate your mortgage with current mortgage rates, rather than having to wait until your mortgage is up for renewal. However, refinancing early means that you will have to pay a mortgage prepayment charge if you have a closed mortgage. This prepayment charge can be 3 months of interest or an interest rate differential. Current mortgage rates will need to be lower for your potential interest savings to cover the cost of breaking your mortgage.
For example, let’s look at a $500,000 mortgage with a 25-year amortization. You signed a 5-year fixed mortgage two years ago at a mortgage rate of 3%. Current fixed mortgage rates are now lower, at 2%. You have three years remaining in your term, so you decide to refinance to get the lower mortgage rate.
You will pay around $3,750 in mortgage break penalties. However, you’ll save around $14,408 in interest savings over the remaining three years. This means that your net savings of refinancing would be $10,658.
There are cases where refinancing to get a lower mortgage rate wouldn’t make sense. If you only have 6 months remaining in your term, then the mortgage penalty will be more than your potential interest savings. In this case, you would have a net loss of $1,286 after the mortgage penalty of $3,750.
It also won’t make sense to refinance if the difference in mortgage rates is small. Using the same example, if your fixed mortgage rate is 2.1% and current mortgage rates is 2%, the small interest savings to be had would be negated through mortgage penalties. In this case, you’ll be at a $1,440 net loss.
To Access Home Equity
Homeowners wanting to access their home equity can do so through a mortgage refinance or by using a home equity line of credit (HELOC). While HELOCs are more popular, they have a lower credit limit. A mortgage refinance allows homeowners to borrow a large amount of money at once, with a low interest rate.
With a mortgage refinance, you can borrow up to 80% of the value of your home. The difference between what you are borrowing and your current mortgage balance would be the amount that you are borrowing, as you will need to pay off your current mortgage balance first.
Mortgage equity withdrawal, which is also referred to as home equity extraction, is a way for homeowners to borrow money using their home equity, without having to sell their home. In a 2019 analytical note by the Bank of Canada, 2 million homeowners used a HELOC in 2017, compared to only 380,000 mortgage refinances. Meanwhile, the average HELOC amount borrowed was $12,000, while the average amount borrowed with a mortgage refinance was $54,000.
In 2017, Canadians took out $89 billion in HELOCs and mortgage refinances, of which $40 billion was through refinancing of a mortgage. Billions of dollars are being borrowed every year, but where is this money being spent?
The Bank of Canada found that 28% of mortgage refinance dollars were spent on debt consolidation. This includes paying down high-interest credit card debt, car loans, and personal loans. Paying off these debts with a low mortgage interest rate allows homeowners to save on interest costs. Meanwhile, 25% was used for home renovations, 25% for consumption, and 22% for investments.
The prevalence of home equity borrowing is seen in spending levels, such as 11% of all renovation spending being borrowed through home equity, and 0.5% of GDP. Using a mortgage refinance to access home equity is a low-cost way for homeowners to consolidate debt and to spend.
Rising Rates
In a borrower’s nightmare scenario, mortgage rates are skyrocketing and borrowers are scrambling to lock-in their mortgage rates before they rise further. If your mortgage is up for renewal in two years, but you know that mortgage rates will increase in one year, will it make sense to refinance early? The answer of course lies in the difference in rates.
While it’s of course not possible to predict future mortgage rates, let’s say that you know for certain what future rates will be. You have a fixed mortgage rate of 3% that has a remaining term of two years. Market interest rates have been rising quickly, and you’re worried that rates will be higher when it’s time for you to renew. Current mortgage rates are at 3.5%, but you know that they will increase to 5% in two years, not far off from Desjardins’ projected 5-year posted fixed mortgage rate of 4.55% to 6.95% by 2024.
If you choose not to refinance, your mortgage rate at renewal will be 5% in two years. It will then be 5% for the next 5 years. If you do refinance, your mortgage rate will be 3.5% for two years, then 3.5% for the next 3 years.
In this scenario, you’ll be paying 3.5% instead of 3% for two years, but then you’ll be paying 3.5% instead of 5% for three years. If you know that mortgage rates will rise significantly in the future, refinancing can help you lock in a low mortgage rate, even if it’s higher than your current mortgage rate.