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Refinancing at a lower mortgage rate

One great reason to refinance your mortgage is to secure a lower mortgage rate, saving yourself money over time. Just ensure that your refinance penalty—which is calculated several ways—doesn’t exceed your potential savings.

Example savings through a refinance

Let’s look at a detailed calculation assuming you have a home valued at $350,000 with an outstanding $250,000 mortgage. You are 2 years into a 5-year term with a fixed rate of 5.0% and are considering a new 5-year term at 3.5%. Throughout the example, we will examine refinance savings and costs.

To evaluate the interest savings, you start by calculating the difference between mortgage rates. You then apply this to your mortgage balance for the remaining 3 years left in your 5-year term:

Step 1 : Determine interest savings

   5.0% (existing mortgage rate)

- 3.5% (new mortgage rate)

= Interest rate differential: 1.5% 

1.5%interest rate differential x $250,000 outstanding mortgage x 3 remaining mortgage term = $11,250 interest savings at lower rate

The major cost of refinancing is your mortgage breakage penalty, which is supposed to capture the lost revenue to your lender when you terminate your mortgage contract. On a fixed rate mortgage you will pay the greater of 3 months interest or interest rate differential. On a variable mortgage, you will only pay three months’ interest. Since our example involves a fixed mortgage rate, we must determine both 3 months interest and the interest rate differential (IRD) and choose the greater.

Step 2 : Determine 3 months interest penalty

   5.0% (existing mortgage rate)

x $250,000 (outstanding mortgage)

x 3 months

÷ 12 months

= $3,125 (3 months interest penalty)

Step 3 : Determine interest rate differential (IRD) penalty

   5.00% (existing mortgage rate)

- 4.05% (current posted 3-year fixed rate)

÷ 12 (to convert to monthly)

= Interest rate differential (IRD): 0.08%

    0.08% (IRD)

x $250,000 (outstanding mortgage balance)

x 36 (months remaining in term)

= Interest rate differential (IRD): $7,200 

Now that we have calculated both 3 months interest and the IRD, we see that the IRD is a bigger penalty, which will be used to calculate the refinance savings.

Step 4 : Determine savings through a refinance

   $11, 250 (interest savings at lower rate)

- $7,200 (refinance penalty)

= Refinance savings: $4,050 

Under this example, refinancing would give us $4,050 in savings.

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Additional considerations

In some cases you may be responsible for legal fees associated with registering a new mortgage on your property. As a general rule however, if your mortgage loan is between $250,000 - $300,000, your lender or broker will often cover legal fees.

When refinancing to a lower mortgage rate, you should also consider using some of your equity to consolidate debt or finance other projects. As of July 9th, 2012, the maximum loan to value ratio on a refinance is 80%.

For example, on a home worth $350,000, you can have a mortgage of $280,000 (80% * $350,000). Comparing the $280,000 to the existing mortgage balance of $250,000, you can take an additional $30,000. If you do have outstanding credit card debt, an auto loan or a personal line of credit at a higher interest rate, then you can combine all of this debt into your mortgage.

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