Martin's Mortgage Maneuver
How to Avoid Huge Mortgage Break Fees and Take Advantage of Today's Low Rates
Disclaimer: this is not financial advice. You are solely responsible for all outcomes associated with taking any or all of the following steps. If your home is worth more than $1,000,000 and was purchased after 2016 then there may be some limitations on your ability to refinance your mortgage.
What I am about to share with you are a few simple steps that may allow you to avoid the enormous fees charged by banks if you break your mortgage. I did not set out to discover this. I was simply trying to avoid my own exorbitant break fee. As it turns out, this has not only saved my family tons of money, it has helped several of my friends as well. Some have saved as much as $35,000 in mortgage break fees. I have chosen to share this so that you can benefit too.
What follows is quite dense. I am confident it will be worth the read if you:
Have a fixed-rate mortgage at a rate of more than 1.64%;
Want to save thousands of dollars by taking advantage of today’s low mortgage rates; and/or
For personal reasons, need to break your mortgage and are being quoted an outrageous fee.
Here is a brief summary of the main points:
When you break your mortgage, Canadian banks charge you a fee.
This fee is based on either three months' interest or the interest rate differential (IRD), whichever is highest.
The most exorbitant break fees are always based on the IRD.
On the day you sign your mortgage your IRD is, by definition, $0.
Six months after signing your mortgage the IRD explodes, resulting in enormous break fees.
But...
When you blend-and-extend your mortgage you sign a brand-new mortgage: think $0 IRD.
When you then break your new mortgage, you reduce the break fee by up to 90%.
After breaking your mortgage you can sign up for a new mortgage at today’s low rates and save tens of thousands of dollars.
I call this … Martin's Mortgage Maneuver.
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Backstory:
In December 2019, my family purchased our first home. We took on a five-year, fixed-rate mortgage at 2.49%. Our mortgage was $504,000.
In April 2020, mortgage rates had fallen to 2.25%. Out of curiosity, I called our bank to see what it would cost us to break our mortgage. Our mortgage balance was now $498,000. The bank quoted me $3,100 to break our mortgage. The Prepayment Charge had been calculated based on three months' interest:
Prepayment Charge = $498,000 remaining mortgage * my 2.49% interest rate * 3/12 months
Prepayment Charge = $3,100
By October 2020 our bank’s mortgage rate on a five-year, fixed-rate mortgage had dropped to 2.0%. Rates at other banks were now as low as 1.74% (FYI – as of December 2020, they were as low as 1.64%).
Using an online mortgage payment calculator, I realized that I'd save roughly $14,250 if I could refinance my 2.49% mortgage at 1.74% over the next four years. I only looked at the next four years of savings because I had roughly four years left on my 2.49% mortgage.
So, in October 2020, I called back our bank to confirm the $3,100 break fee. I assumed it would be slightly lower than in April because we now had only $490,000 left on our mortgage. Instead, the bank quoted me a mortgage break fee of nearly $28,600.
Let me just pause here for a minute to recap.
*** six months later my break fee had increased by over $25,000 ***
My break fee was no longer based on three months' interest. It was now based on the interest rate differential (IRD). The Prepayment Charge (or break fee) using the IRD was calculated as follows:
IRD Prepayment Charge = Mortgage Amount * Years Outstanding * (Your Actual Rate (A) - The Bank's Current Rate (B))
The mortgage amount ($490,000) and years outstanding (4 years and two months, or 4.167 years) were both straightforward calculations. The calculation of "A" and "B" was not straightforward.
Let me break down those calculations for you.
How to calculate "A" or "Your Actual Rate":
Banks use their Posted Mortgage Rates, which are the banks' "official" mortgage rates. The Posted Rate is an inflated rate that nobody ever pays when they sign up for a mortgage.
To arrive at your actual mortgage rate, banks discount their Posted Rate. The Discount is a derived calculation representing the spread between your bank's Posted Rate when you signed your mortgage and the mortgage rate that you received. In December 2019, I signed a mortgage at 2.49%. In December 2019, my bank's Posted Rate on a five-year, fixed-rate mortgage was 5.29%. To get to my 2.49% mortgage rate my bank applied a Discount of 2.8%.
You should be able to see your Actual Rate, the Posted Rate, and the Discount that you received in your mortgage contract. A few banks (like Tangerine Bank, who I’m now with) don’t use Posted Rates and their break fees are always more reasonable.
How to calculate "B" or the "Bank's Current Rate”:
To calculate “B” banks subtract the Discount that you received on your mortgage (i.e. 2.8%) from their current Posted Rate on the "most similar" mortgage on the day that you break your mortgage.
Here’s what it looked like for me.
April 2020:
In April, I had four years and eight months left on my mortgage. The "most similar" mortgage to my mortgage was therefore a five-year, fixed-rate mortgage. So, my bank used its April 2020 Posted Rate on its five-year, fixed-rate mortgage, which at the time was still 5.29%. My IRD Prepayment Charge was calculated as:
IRD Prepayment Charge = $498,000 mortgage * 4.66 years * (A - B)
IRD Prepayment Charge = $498,000 mortgage * 4.66 years * ((5.29% - 2.8%)- (5.29% - 2.8%))
IRD Prepayment Charge = $2,320,680 * (2.49% - 2.49%)
IRD Prepayment Charge = $2,320,680 * 0.0%
IRD Prepayment Charge = $0
As you can see, since A minus B equaled 0.00%, the IRD Prepayment Charge was $0. Because the IRD Prepayment Charge was $0, my bank quoted me the three months' interest Prepayment Charge, or $3,100.
October 2020:
In October, I had four years and two months left on my mortgage. The "most similar" mortgage to my mortgage was therefore a four-year, fixed-rate mortgage. So, my bank used its October 2020 Posted Rate on a four-year, fixed-rate mortgage to calculate my Prepayment Charge. The Posted Rate on its four-year, fixed-rate mortgage in October 2020 was 3.89%. My mortgage was now down to $490,000. Therefore, my IRD Prepayment Charge was calculated as:
IRD Prepayment Charge = $490,000 mortgage * 4.167 years * (A - B)
IRD Prepayment Charge = $490,000 mortgage * 4.167 years * ((5.29% - 2.8%)- (3.89% - 2.8%))
IRD Prepayment Charge = $2,041,830 * (2.49% - 1.09%)
IRD Prepayment Charge = $2,041,830 * 1.4%
IRD Prepayment Charge = $28,585
As you can see, my IRD Prepayment Charge ballooned because my bank was now using a much lower four-year Posted Rate (3.89%) than the five-year Posted Rate it had used back in April (5.29%). Banks employ steadily declining Posted Rates as mortgages approach maturity, which keeps the IRD Prepayment Charge high. Except in the first six months.
Notionally, if I had broken my mortgage six months less a day into my mortgage, I'd have paid a $3,100 Prepayment Charge (based on the five-year Posted Rate). If I had broken one day later, or exactly six months into my mortgage, my Prepayment Charge would have jumped to $28,585 (based on the four-year Posted Rate). In short, the timing of when you break your mortgage matters a lot because it is the sole determinant of which Posted Rate the bank is going to use to calculate your Prepayment Charge. One day can make a huge difference.
Here’s the good news:
This approach to calculating the IRD Prepayment Charge can also be used to your advantage. As you may have observed, on the day that you sign your mortgage, the IRD Prepayment Charge is, by definition, $0. Indeed, so long as your mortgage is still "closest" to being a five-year mortgage on the day that you break it, then the bank will use its five-year Posted Rate to calculate your IRD Prepayment Charge. If the five-year Posted Rate hasn't changed since you signed your mortgage, then the IRD Prepayment Charge will be $0. That's because "A" and "B" are identical, which means that A – B will net out to 0.00%. Even if the bank's five-year Posted Rate drops in the months after you sign your mortgage, it's likely to be by a much smaller amount than if the bank applied the four-year Posted Rate to calculate the IRD Prepayment Charge.
To get around the $28,585 IRD Prepayment Charge, I did a "blend-and-extend". With a blend-and-extend, I blended the remaining 4.167 years of my existing mortgage at 2.49% with a 0.833-year mortgage at the current 2.00% mortgage rate offered by my bank. This resulted in a brand new five-year, fixed-rate mortgage with a "blended" interest rate of 2.41%.
Once my bank had calculated the 2.41% mortgage rate, it subtracted this amount from the October 2020 Posted Rate on a five-year, fixed-rate mortgage (now at 4.79%) to derive a Discount of 2.38%.
I then broke this brand new 2.41% mortgage. Since I had just signed the mortgage, the IRD Prepayment Charge was $0. Specifically, my IRD Prepayment Charge was calculated as follows:
IRD Prepayment Charge = $490,000 mortgage * 5.0 years * (A - B)
IRD Prepayment Charge = $490,000 mortgage * 5.0 years * ((4.79% - 2.38%)- (4.79% - 2.38%))
IRD Prepayment Charge = $2,450,000 * (2.41% - 2.41%)
IRD Prepayment Charge = $2,450,000 * 0.0%
IRD Prepayment Charge = $0
Since the IRD Prepayment Charge was $0, the bank charged me three months' interest or $2,952, calculated as:
Three Months’ Interest = $490,000 mortgage * .0241% interest rate * 3/12 months
Three Months’ Interest = $2,952
*** By blending-and-extending my mortgage before breaking it, I reduced my Prepayment Charge from $28,585 to $2,952, for a net reduction of $25,633 ***
I am now on a new five-year, fixed-rate mortgage at 1.74%. Over the next four years, my family will save roughly $10,000 in after-tax dollars (and avoid a $28,585 break fee). This is after accounting for all fees associated with breaking my mortgage, i.e. the $2,952 Prepayment Charge plus approximately $1,200 in other refinancing charges.
So, there you have it. The mechanism I discovered to avoid the banks’ exorbitant mortgage break fees.
Aka Martin's Mortgage Maneuver.
I hope you found this helpful!
If you have any questions, I’ve created an FAQ page.
Also see "Martin's Mortgage Maneuver: Part Deux", which explores how you can refinance your mortgage to create low-risk, passive income.
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