Interest rate differential is a big phrase that comes up if you are considering refinancing your mortgage. You might be in an unfortunate situation where you need to consider refinancing or you may be noticing significantly lower rates than when your term started. Either way, interest rate differential is one of the big things to consider as you explore whether refinancing is right for you. Let's explore what interest rate differential is and how to deal with it in a way that won't have too much impact on your mortgage.
What is Interest Rate Differential?
Simply put, interest rate differential is the difference between your current interest rate on your mortgage and the new interest rate you will be locking into.
Let's say you have a mortgage for $250,000. When your mortgage term started, you locked into a five year term at 3.29%. At this point, you have 2 years left on your term. Interest rates are now 2.79%. The interest rate differential between these two mortgages is 0.5%. Fairly simple.
Interest Rate Differential and Mortgage Penalties
The question of interest rate differential is most often couched in the question of "How much will it cost to get out of my mortgage?"
The next step in determining this is to take the interest rate differential and pair it with the number of years left in your mortgage term.
With the example above, there are 2 years left in the mortgage term. To calculate the penalty, you multiply the mortgage amount ($250,000) by the interest rate differential (0.5%) and then multiply that number by the number of years remaining in the term (2).
( $250,000 x 0.005 ) x 2 = $2500
In this example, the cost of getting out of your mortgage is $2500.
Obviously any of these numbers are interchangeable. You might have a mortgage of $400,000 and an interest rate differential of 1% with 2 years remaining.
( $400,000 x 0.01 ) x 2 = $8000
The cost of getting out of your mortgage then will be $8000.
How to Minimize Mortgage Penalties
If you are in a position where you are needing to refinance, there are a number of things you can do to keep the cost of refinancing down.
Avoid "Discounted" Mortgage Rates
One of the tricky things mortgage lenders can do is manipulate how the interest rate differential is calculated. This is often done by larger lending institutions like any of the big banks in Canada.
These institutions will have an advertised interest rate but will often give you a "discounted" rate in order to compete with their competitors. Let's say this "discounted" rate is 1% lower than the advertised rate.
What often happens with a refinance scenario is this. The interest rate differential is calculated using the advertised rate instead of the "discount" rate that you thought was so amazing. What you thought was great news for your mortgage is suddenly a thorn in your side!
Looking back at the example of the $400,000 mortgage with 2 years left in the term, the interest rate differential is now 2% and your mortgage penalty is $16,000!
( $400,000 x 0.02 ) x 2 = $16,000
Unless you can recoup the cost of that with your new mortgage term, that is a big price to pay.
Variable Rate Mortgages
A second way to keep the cost of refinancing down is to stay away from fixed-rate mortgages where the cost of refinancing is highly dependent on how long your term is.
Instead, variable rate mortgage penalties are calculated using a three month interest payment formula. This type of penalty often ends up being significantly less than an interest rate differential penalty.
You can read more on variable vs fixed rate mortgages here.
A third way to stay away from large refinancing penalties is to avoid large lenders. The saying "big bank, big penalties" is very true when it comes to refinancing. The "discounted" rates of big lenders aren't so friendly when it comes to a refinance situation.
An alternative is to go with monoline lenders such as First National, MCAP and the like for your mortgage needs. These smaller institutions specialize in mortgages and don't distinguish between an advertised rate and a discounted rate. With these lenders, there are no surprises when it comes to calculating your interest rate differential.
Finally, if possible, avoid refinancing altogether or keep the window of time before your term expires minimal (if possible). Obviously life can throw you curveballs and you can't always control when you might need to renew your mortgage term. But when possible, be aware of where you are at in your term and think carefully about the cost of refinancing.
As always, never hesitate to reach out to a professional mortgage broker to assist you with this process or even to analyze whatever scenario you are facing. We are always here to help and will be glad to assist you with any questions you might have when it comes to your mortgage.