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The complete guide to refinancing your mortgage

a couple reviewing their finances in order to refinance their mortgage

Mortgage rates fluctuate based on your income, debt levels and how long you want to borrow the money. The interest rates that influence your mortgage rate will increase or decrease based on a variety of macro-economic conditions, including inflation, investor confidence and economic growth. In a year with a pandemic crisis and record job loss, mortgage rates are now at an all-time low as governments and lenders try to stimulate the economy and encourage us to spend.

Data from the Mortgage Professionals of Canada shows that homes purchased in 2019 had an average mortgage rate of 3.14% (not including refinance loans). These rates were already low but fast-forward to the end of 2020, and mortgage rates have dipped to historic lows of 1.99% for a five-year, fixed-rate mortgage.

The question many Canadians are now asking is: can we save money by refinancing our mortgage?

To help you decide, here is a  guide on when to capitalize on an interest rate drop. We provide reasons to refinance, explain when it’s a good idea to refinance a mortgage, highlight the requirements to qualify and elaborate on how to refinance your mortgage, along with a few additional resources.  

What is a mortgage refinance?

Refinancing your mortgage means replacing your current mortgage loan agreement with a new one. People usually renegotiate the terms of their loan to access the home’s equity or save money by taking advantage of a lower interest rate. 

definition of what it means to refinance your mortgage

Unlike a renewal, a mortgage refinance requires homeowners to reapply and requalify for a mortgage — even if you are working with the same lender.  In order to qualify for a mortgage, your lender will need to examine the following: 

  • Your income-to-debt ratio; 
  • The loan-to-value ratio on your current home; 
  • The appraised value of your home. 

Keep in mind, you typically need 20% equity in your home to refinance; however, if you have less than 20% equity and an excellent credit score, your lender may be able to qualify you for the refinance. 

4 Reasons to refinance your mortgage

People choose to refinance to save money or to access money. The four reasons to refinance below stem from these primary goals. 

1. Lower your interest rate

One way to save money over time is by paying lower interest on your loan. If the current interest rate is significantly lower than when you first purchased the home, you may want to consider refinancing the mortgage. 

For example, if you originally had a 3.8% interest rate, refinancing at a 2% interest rate would lead to significant savings over time. A homeowner with a 20-year fixed-rate loan for $300,000 is spending $1,774, about the same as before, only now you’ve shaved five years off the debt repayments and saved tens of thousands in interest repayments.

2. Shorten the term

When interest rates are low, homeowners may have the chance to secure a new loan that has a shorter term with minimal change to monthly payments. This saves them money in the long term and helps them build home equity faster. 

For example, if you have a 20-year fixed-rate mortgage with an interest rate of 3.8% on a $300,000 home, your monthly mortgage payments will be $1,787. After five years, if the interest rate drops to 2%, you can refinance to a 10-year fixed-rate loan. Payments on the remaining $192,720 will be about the same at $1,774 but you’ll have the mortgage paid off five years faster.  

3. Access the equity

Another motive for refinancing is to access the equity in your home. Equity is the amount you have invested in your home. This grows over time as you make your mortgage payments. 

Mortgage lenders determine the value of a home by using an objective third-party appraisal. This appraisal assesses the home’s current market value to determine its worth. You can access a percentage of your home’s appraised value in cash if you refinance. 

Homeowners often choose to access the equity in their home when planning a big purchase. The CMHC reported that in 2019, 27% of people who refinanced their homes did so to fund home improvements. Home renovations and improvements can increase the value of your property, meaning this investment will pay off in the long-term. 

Another reason homeowners will access their equity is to pay for their kid’s post-secondary tuition.

4. Consolidate debt

Lastly, homeowners with large debt or with multiple loans choose to refinance their mortgage in order to consolidate debt and reduce their overall cost for repaying debt. According to the CMHC, the top reason homeowners refinanced their homes in 2019 was to reconcile debt. Homeowners can decide to refinance at a lower interest rate for a longer-term and use the additional money to pay off higher-interest debts.

graphic that shows pros and cons of refinancing

Cons of refinancing your mortgage

Refinancing your mortgage can be a smart move if done at the right time. To make the best decision, you’ll also want to consider the cons when refinancing your mortgage. 

Cost to refinance

There are costs associated with breaking a mortgage before your term is up. All homeowners who are refinancing will have to pay a prepayment penalty. Other costs you may incur include an administration fee, an appraisal fee, a reinvestment fee or a discharge fee if changing lenders. Before you break the contract, be sure to determine exactly what the total costs will be. 

The biggest cost to be aware of is the prepayment penalty. For variable rate mortgages, the prepayment penalty will be equal to three months interest on your current mortgage. 

For a fixed-rate mortgage, the penalty calculation is known as the Interest-Rate Differential (IRD) and this calculation differs between lenders. Lenders determine the prepayment method based on the amount you’re paying off early, the remaining months on your term, the base rate at the time of your contract and current interest rates. 

In most cases, the IRD is calculated by finding the difference of the discount rate and the base rate listed in your mortgage contract and multiplying it by the remaining term and balance. Let’s say you are three years into a 5-year term and still owe $100,000. Your current, discounted rate is 2.5% but the original base rate was 4%. Subtract 2.5% from 4% to get an interest rate differential of 0.015 (written as a decimal). Multiply this by the number of months remaining on your contract (in this example, 24 months) and the amount still owed. In this example, your penalty to break the mortgage is $36,000. If this cost is more than your potential savings, it’s not worth refinancing. 

Keep in mind, each lender has a slightly different way of calculating the IRD. While it’s good to get a basic idea, it’s always best to call your lender to find out the exact penalty cost for breaking your current mortgage term.

Extending the life of the loan

If you choose to refinance and opt for a mortgage amortization that is similar or the same as when you first started paying your mortgage, then you are essentially starting over. Your monthly payments will be lower, but at the expense of building home equity as fast, and you’ll be in debt for longer than you would be if you stayed on the current mortgage. 

Let’s say you have a 10-year fixed loan and you want to refinance after five years. You decide to refinance the remaining amount at a slightly lower rate but choose to amortize over 10 years. While you’ll have less expensive monthly payments, you’ll be building equity more slowly, paying off the loan for an additional five years and adding interest costs to your overall payment. 

Potential for deeper debt

While refinancing can save you money in the short term, the long term can be costly.

There are a few ways people fall deeper into debt. First, they decide to borrow more money and owe additional interest on the borrowed money. They aren’t able to consistently pay back the debt plus interest and are charged additional late fees. This pattern continues and they find themselves deeper in debt. 

Another pitfall is switching from a fixed-rate interest to a variable-rate interest when rates are low. Over time, rates may go up and you’ll owe more on your monthly payments or less of your money will be used to pay down your debt. 

Lastly, if you lengthen the time on your loan, you’ll be paying additional interest. This will increase your overall cost of the mortgage debt and cause you to be deeper in debt. 

When should you wait to refinance?

Refinancing isn’t always a good idea. In these situations, it may be more beneficial in the long run to wait and refinance in the future.  

graphic that explains when you'd want to wait to refinance

You aren’t far into your current mortgage

If you just moved into your new home, you won’t be very far into your mortgage term. This means your debt will likely be much higher than your home equity. This makes it harder to qualify for a refinance. If you do qualify, the penalty will be higher than it would if you had paid off more of your mortgage. 

This is especially true for fixed-rate mortgages because you’ll typically be paying an interest rate differential as your penalty cost. The IRD is a lot higher if you are only a year or two into your loan term. It’s usually better to wait until you are further into your mortgage contract to refinance. 

The penalty cost exceeds the benefits

When breaking your mortgage contract, you’re charged a penalty. If this penalty is more than your long-term savings, it’s not worth pursuing. 

Your penalty cost will either be equal to three months interest on what you still owe or an interest rate differential (IRD). Let’s say your IRD to break the loan is $12,000 and you’ll be saving $200 per month with a refinance to a five-year fixed-interest loan. You won’t break even for five years, so there is no upside to refinancing because the penalty is equal to the benefits. You want to be sure that your savings will be more than the cost to break the contract.  

You’ll be moving soon

If you’re planning on moving in the next few years, refinancing isn’t your best option for long-term savings. You’re required to pay a prepayment penalty for breaking your current mortgage. This penalty will likely be more than your potential savings if you plan to move soon.  

You’re facing temporary financial problems 

Many people refinance to access money. This is a helpful strategy for a long-term big-ticket investment, but not a good solution for those who need temporary financial help and, in some cases, those in a crisis. Accessing your equity to solve a temporary financial problem is not a good idea because it typically leads to more debt, plus you end up paying fees to access money. Cash flow issues should be solved by other means such as a personal loan, a cash advance on a low-interest card or a HELOC.

Requirements to qualify for a refinance

Once you decide that refinancing is your best option, you’ll need to qualify. When reviewing your information, lenders will consider the following factors. 

Graphic that shows what you need to qualify for a refinance

Debt

When a lender is evaluating your case, they will look at your ability to pay your mortgage. To evaluate this, they will find your Gross Debt Service (GDS) and Total Debt Service (TDS). The GDS looks at the percent of your income that’s needed to pay your monthly housing costs. An acceptable ratio is typically around 35%. The TDS evaluates the percentage of your income that will cover housing costs (which is GDS) AND any other debts such as car payments. The acceptable ratio for GDS is usually around 42%.

You’ll likely have some debts, but what’s important is the percentage in relation to your income. If you have a high amount of debt and don’t have the means to cover it, it will be difficult to get approved for a mortgage refinance. 

Home equity

You can build home equity in two ways. Either you pay down your mortgage or the value of your home increases. If your home has high market value and you’ve paid off a large portion of your loan, it’s seen as less of a risk for lenders. If your home equity is low because you haven’t paid off much of your mortgage, the lender would have more to lose if you default on your loan. Those who have low home equity may need to wait to pay off more of their loan before refinancing.

Credit score

Whenever you apply for a loan, lenders consider your credit score. While you don’t need a perfect credit score, the better your credit, the better chance you have at getting a loan approved at the low interest rate you’re requesting. 

Your credit score tells the lender that you have a history of paying off your debts on time. If your credit score is too low to refinance, consider taking the time to fix your report’s errors and pay down current debts consistently on time. 

Income

Lastly, your income will be a consideration. Lenders want to see that you have a consistent income source that will allow you to cover the monthly mortgage payments on time. Your income will be evaluated in relation to your debt in the GDS and TDS ratios. 

How to refinance your mortgage

The ONLY way people refinance their home is by breaking their existing mortgage contract and entering into a new one with either the same or a different lender. To do this, you must first find out if you can break your current mortgage and what the terms are for breaking it. 

Graphic of the timeline for refinancing your mortgage

Be sure you are aware of all the costs before breaking your existing mortgage. Some penalties may include:

  • A prepayment penalty
  • An administration fee
  • An appraisal fee
  • A reinvestment fee
  • A fee to remove or change your mortgage
  • Cashback you received when you first got the mortgage

It’s best to talk to your current lender to find out the costs for breaking your mortgage and see what your options are for refinancing with them. Then you can enlist the help of a licensed Canadian mortgage broker to assist you with comparing rates and terms from other lenders. They will help you find a suitable lender and file the necessary paperwork for approval. 

Whether you find a new lender or refinance with your current one, you’ll have to qualify for a new mortgage by passing a mortgage “stress test.”

You’ll need to have all your paperwork in order before applying for the new loan. This includes the loan application, your current mortgage details, identification documents, tax return statements, credit report and proof of income. Once this is submitted, the lender will do a title search to ensure the property isn’t being used as collateral for any other debts. They may also require an appraisal to determine the value of your home; if this is necessary, the lender will send an appraiser to your home although you may end up paying the appraiser’s fee.

Once all the information is collected, an underwriter will evaluate your finances to determine how much of a risk lending would be. From there, they will let you know if you’ve been approved for this new loan.  

The whole process of breaking your existing loan contract for a refinance can be as fast as two to five days if everything is in order, but usually takes closer to two to four weeks from start of comparison shopping, to submission of documentation to final approval; the process can take longer  if there are any complications. Having all the necessary paperwork and scheduling an appraisal can help move this process forward faster.

Alternatives to refinancing your mortgage

While the only way to refinance your mortgage is by breaking the existing contract, there are two other ways to adjust your current loan agreement: by creating a blended rate or by adding a Home Equity Line of Credit. 

Create a blended rate

Rather than breaking your current mortgage, some lenders will allow you to extend it. This is also called an early renewal. In this option, your old interest rate and new terms are blended together. You aren’t required to pay a prepayment penalty, but there are still administrative fees.

With a blended rate, you aren’t getting the lowest interest rate, but you can still lower your rate from where it originally was. If the interest rate has dropped significantly since you first bought the house or if you want to access equity, this could be an option. 

graphic that shows how to calculate a blended rate

Be sure to ask how your lender calculates this new blended rate. Typically it’s calculated in these five steps: 

  1. Take your old interest rate and multiply it by the number of months remaining in your contract. For example, let’s say you have 20 months left at a 5.5% rate. This gives you 110. 
  2. Then take the number of months in your new term and subtract the number of months in your old term. Let’s say the new term is 60 months. When you subtract 20, you get 40 months. 
  3. Next, multiply the new interest rate by the difference of months. Let’s say the current rate is 2%, so we multiply that by 40 to get 80.
  4. Add steps 1 and 3 together to get 190. 
  5. Divide that by the number of months in the new term, so 190 divided by 60 is 3.17. Your new blended rate would be 3.17% for the next 60 months. 

In the example, the difference in rates is significant, so the blended rate is notably lower. If the two rates are similar, the blended rate won’t be very different from your original rate. If this is the case, a blended rate might not be beneficial for you.

Add a home equity line of credit (HELOC)

A Home Equity Line of Credit is not a mortgage refinance but a variable rate loan secured by the value of your home. If you’re considering refinancing to access equity, you may decide a HELOC is a better option. Since you are adding a line of credit rather than breaking your current mortgage, there is no prepayment penalty on a HELOC.

A stand-alone HELOC allows you to access up to 65% of your home’s market value in a revolving line of credit. So if you purchase a home for $500,000, you can access up to $325,000 in a HELOC. 

Unlike a traditional mortgage, a HELOC only requires you to make regular payments against the interest of the borrowed money. Homeowners can choose to pay down the principal amount as well, but it’s not required and there is no penalty if they choose not to. While this can be a short-term credit advantage, it may lead to a long term debt problem if you continue to pay interest on a principal that is never paid off. 

Beware of refinancing scams

Unfortunately, there are scammers out there ready to take advantage of your financial situation. They see a loan refinance as a natural way to get access to all your personal and financial information. To avoid these unfortunate situations, be aware of these red flags.

Red flag 1: Upfront fee payment is required

A scammer may reach out to you through email or phone about a refinance and request an upfront fee to start the process. They may claim that this fee will guarantee the loan or be used to start the application process. Either you’ll pay the fee and never hear from them again, or they’ll request your banking information to initiate the transfer of the fee, which will give them access to your financial accounts and the opportunity to steal your savings.

While real lenders will charge processing fees, they will deduct them from the loan amount or include them in your contract rather than ask for them upfront. Charging an upfront or application fee is illegal. 

Red flag 2: Requests an immediate change in payments

If you receive an unsolicited mortgage refinance offer, the fraudulent lender may request you immediately stop paying your current mortgage and reroute the money to this new loan. As you’ve learned by now, the loan process takes time and an application is needed. You’ll be required to have a credit check and may need a home appraisal. You won’t be asked to change your mortgage payments immediately.

Red flag 3: The loan refinance is unsolicited

Be wary if someone is calling or emailing you with an offer out of the blue. Likely, the deal won’t be as good as they promise. If you are interested in refinancing, find a mortgage broker who has good reviews or shop around and talk to lenders yourself. 

Red flag 4: The lender is not registered

Before giving any information to a lender, be sure they’re registered in your province. Also, verify that loan companies have Better Business Bureau accreditation. You should also be able to confirm a physical address of the location as well as find their website online. These details are important for confirming that the person or business is real and trustworthy. 

Red flag 5: They offer everyone approval

If the lender appears to guarantee approval to everyone and does not require a credit check, it’s likely a scam. A credit check is required for all loans. It’s too risky for lenders to invest in those with very low credit scores and a large amount of debt. Be wary of deals that seem too good to be true.

Graphic that gives tips on how to spot a refinance scam

If you believe you were a victim of a loan scam, be sure to contact your bank and report it to the Canadian Anti-Fraud Centre.

Resources for refinancing your mortgage

Trying to decide if refinancing your mortgage is a good financial decision? Here is a list of resources that can help you evaluate your situation. 

With interest rates so low, refinancing your mortgage could be a smart move. While the process might seem complicated at first, it’s relatively simple once you know your options. For more information on refinancing your mortgage, contact a licensed Canadian mortgage broker or learn more on the Zolo Blog

Sources:

Bankrate | Mortgage Professionals Canada | CIBC | Investopedia | Government of Canada | Government of Canada | Canadian Mortgages Inc. | ratehub.ca | Hoyes | Canadian Mortgage Trends

Image of Romana King

Romana King

Romana King is an award-winning personal finance writer, real estate expert and the current Director of Content at Zolo Homebase. Romana has contributed to business and lifestyle publications including CBC.ca, Toronto Sun, Maclean’s, MoneySense, Globe & Mail Custom Content Team, and The Toronto Star. Among her achievements, Romana won silver for her annual Where to Buy Now real estate package in the 2019 Canadian Online Publishing Awards. In 2015, she won a SABEW Business Journalism award. When she was editor of CI Top Broker, Romana helped guide her team to obtain its first KRW Business Journalism nomination, and in 2011, she was part of a small team that helped MoneySense win Magazine of the Year at the 34th annual National Magazine Awards. Her north star is to consistently provide actionable, valuable and accurate information that helps elevate the financial literacy of everyone.

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