Refinance or not: A mortgage quagmire

Director of Commercial Lending , First National Financial Corporation
  • Mar. 10, 2015

Darryl BellwoodBorrowing money right now is cheap, and has been for quite some time. Most experts agree interest rates will eventually rise, but the real question is when. 

Instead of focusing on the when, most property owners and borrowers are looking at whether to refinance existing debt to take advantage of low interest rates.

With the ability to borrow cheap money and to refinance existing debt with higher interest rates with new mortgages with lower interest rates, borrowers are asking, “Do I really save money by paying out existing high interest rate mortgage debt?”

The quick answer would be yes. 

More thorough analysis required

However, when you delve into the underlying math, the question is not so easy to answer and a more thorough analysis is required. If the existing debt does not have a prepayment penalty and the mortgage is open, then yes, it is cheaper to payout the existing debt and refinance. Not all debt is open to prepayment, though, and in many cases it has a prepayment penalty in order to break the existing mortgage. 

The prepayment penalty is usually an interest rate differential (IRD). This penalty bases its calculation on the present value of existing cash flows and the mortgage maturity balance using the coupon rate of the mortgage and what is termed the reinvestment rate in the market (the reinvestment rate is a Government of Canada Bond Yield with a similar maturity to that of the mortgage). 

Quite often the IRD can be very large and depends on such factors as the length to maturity of the mortgage, the outstanding balance, the mortgage coupon rate, the remaining amortization period and the yield used from the matching Government of Canada Bond Yield. Once the IRD has been determined, we can complete a mortgage refinance analysis.

Focusing on the debt side

My analysis focuses on the debt side and the costs to break the existing mortgage and the costs to refinance the mortgage. However, there are additional considerations the borrower also has to consider. They range from income taxes, capital cost allowance to available equity as just a few. Another is the time value of money. 

A borrower has to realize the prepayment penalty is paid up front in cash and is an out-of-pocket cost they are responsible for. By refinancing early, in theory you recoup that cost over time by paying a lower interest rate. However, since the value of money depreciates over time, the cost actually increases the longer it takes into the new term to recoup the funds.

Let’s look at a hypothetical scenario where an IRD penalty is $400,000. The corresponding hypothetical mortgage to generate this penalty has a current outstanding balance of approximately $2,000,000 with a term to maturity of 81 months (approximately six years and nine months), a remaining amortization period of 214 months (just under 18 years) and a mortgage coupon interest rate of 5.25%. 

At the time this IRD penalty was calculated, the yield on the associated Government of Canada Bond was 0.75%. You can see the difference between the mortgage coupon interest rate of 5.25% and the GOC yield of 0.75% is 4.50%, which would be the biggest contributing factor associated with such a large IRD penalty on the mortgage. 

I then compare the cost of the penalty with the total interest paid from the proposed date of payout to the maturity date on the existing mortgage. In this example, it would be approximately $495,000 of interest paid until maturity and when compared to the IRD penalty of $400,000, would save the borrower $95,000. 

However, the $495,000 is an out-of-pocket cost for each scheduled mortgage payment, whereas the penalty is an out-of-pocket cost today for the total amount and is affected by the time value of money.

The second thing to consider is interest rate on the new mortgage, and to see what the total interest costs on refinancing only the amount of the existing balance. Let’s assume the borrower in this scenario is able to secure new financing on the property for a new 10-year term at 2.50%. 

In this scenario, the existing balance of $2,000,000 with an interest rate of 2.50% would incur interest costs for 81 months of approximately $244,000. On the surface it appears the borrower has saved the difference between the interest to maturity on the refinanced mortgage and the difference between the interest to maturity on the old mortgage of $251,000 ($495,000 – $244,000). Adding this to the savings from the IRD penalty and the total would be approximately $346,000. 

Borrower is not limited

However, it should be noted the borrower is not limited to refinancing only the existing mortgage balance but they also have the option to draw equity out of the property. This counteracts the out-of-pocket cost of the prepayment penalty, since equity can be used to cover it.

One of the positives to refinancing in the middle of the term is that in this low interest rate environment, a borrower can take the additional term and lock in the low interest rate for a term that is longer than the remaining term on the existing mortgage. This helps to secure a low interest rate considering interest rates are expected to rise over time.

Refinances of mortgages, however, do have other cost considerations that need to be considered. The completion a mortgage refinance would incur new legal costs to register the new mortgage, a new appraisal, a new environmental report and a new building condition report. These additional costs should always be reviewed and offset against the benefits of the refinance. 

While every mortgage has unique terms which can make each analysis different, it is easy to run the analysis to determine the pro and cons for each scenario. Considering how low interest rates have dropped, it can only benefit you to take a look at the scenario.

Darryl Bellwood is a Director of Commercial Lending with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at [email protected].

Darryl Bellwood is the Assistant Vice President, Commercial Financing with First National Financial, Canada’s largest non-bank lender. Darryl provides commercial mortgage financing solutions for all types of commercial real estate…

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Darryl Bellwood is the Assistant Vice President, Commercial Financing with First National Financial, Canada’s largest non-bank lender. Darryl provides commercial mortgage financing solutions for all types of commercial real estate…

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