In Canada, borrowers generally do not repay their mortgage over the term of their loan. The loan is instead usually amortized over a period of 15 to 30 years. Needless to say, a shorter amortization period means lower interest payments over the total life of the loan, but higher monthly payments. Conversely, a longer amortization period means you will end up paying more interest over the life of the loan, but will have smaller cash outflows at the end of each month. What this means is that most borrowers who obtain mortgage financing through a traditional financial institution have to renew the mortgage at least once, but most often several times, before it is paid off in full.
When this happens, it gives rise to two options that homeowners have to choose from: (i) a renewal of the mortgage, or (ii) refinancing the mortgage. This article therefore serves to outline the individual features of both options, as well as their inherent benefits and risks for the borrower in question. As you will see, depending on the borrower’s unique circumstances and outlook of markets, each option can be compelling in its own way. However, before we delve into the granular details, it is worth outlining what each of these two options effectively entail.
There are many instances when it makes good financial sense to refinance a mortgage instead of just renewing it for another term. In a refinancing, the borrower is essentially taking out a separate loan to pay off the current loan. This separate loan would ideally have a lower interest rate, shorter term, allow the borrower to increase their loan amount and take out extra cash from the available equity in their home, and/or allow the borrower to switch from an adjustable rate mortgage to a fixed rate one or vice versa.
The two most common reasons cited for a mortgage refinancing is to take out extra cash from equity that is available in the home and/or take advantage of a lower interest rate. Interest rates are based on prime rates set by the central banks of each country. Depending on economic conditions and outlooks, these central banks might toggle the prime rate up or down. Banks then react accordingly with their own rates. If you as a borrower obtained a loan at a time when the rate was higher, then you can refinance the loan to take advantage of the lower rate, which can save you a few thousand dollars in interest. Refinancing can also be done to switch between an adjustable or fixed rate. All other things being equal, adjustable rate mortgages usually start at lower rates than fixed rate mortgages. Thus, switching between the two is a choice to be made depending on your outlook of where rates will go over the next few years.
While these reasons are compelling in of themselves, there are also other factors at play here that can make refinancing a good decision, depending on the borrower’s individual circumstances. One of these factors is to tap into the equity within the home. Home equity is defined as the value of the home on the market less the amount of mortgage debt still remaining to be paid down. As a loan is paid down, the borrower’s equity in the home increases. Given the rising home prices across Canada in the recent few years, this equity has been on the rise for homeowners. The most common way to tap into this equity is via a debt instrument called the home equity loan.
A home equity loan is essentially a second mortgage loan on your home. In this case, you keep the mortgage and take out another loan with the equity in your home as collateral. This is either provided as a lump sum or as a home equity line of credit (HELOC). In a HELOC, you only pay interest on the amount you borrow. Thus, a refinancing can be used to unlock access to these funds and ensure continuous access without the need to requalify each time you want to withdraw money for your personal expenses.
Another reason that a mortgage refinancing can be deployed towards is a debt consolidation. In our day-to-day lives, there are several debts that we may incur. The most common one is probably credit card debt, which accumulates at up to 23% interest or even more! Another common form of debt is student debt, which also typically incurs at a higher rate than a mortgage. For debts like these, a debt consolidation can be very useful. The way it works is that a new loan is taken out that is used to pay off all this debt. The borrower subsequently pays back interest at a lower rate. To illustrate, consider this example below:
Borrower A has an outstanding mortgage of $50,000, an outstanding credit card bill of $15,000, and student loans outstanding of $35,000. Collectively, this equals $100,000 of debt. However, the credit card bill needs to be paid back soon or it will start incurring 23% interest. It’s a similar story with the student loans. If Borrower A does not act fast, he/she could be stuck paying these interest rates and falling into an endless cycle of debt. An alternative option would therefore be to obtain a refinanced 2nd mortgage in the amount of $100,000 which is provided at a rate of 6% for example, or refinance your entire mortgage and add the $100,000 to the newly refinanced mortgage at a rate of 2.89% for example. Borrower A now uses the funds to pay off the student loans, old mortgage and credit cards in full, and then pays the lower rate on this new loan.
A renewal is essentially a status quo. Whatever you as a borrower locked into in the past is now carried forward for another term, with the exception of the interest rate, which can be lower or higher depending on the rates offered at the time of renewal. In a scenario where the borrower has a less favourable outlook on interest rates going forward, it could make sense to simply renew the loan. A third option is also to transfer the loan. At the time of renewal, the borrower is allowed to explore options besides the current lender and transfer their remaining mortgage balance to an option that aligns better with their preferences. If you feel that another financial institution has lower interest rates, better mortgage terms, better customer service standards and/or offers ancillary benefits that are not available at your current financial institution, then you can pursue a switch/transfer. This switch does not have to mean a refinancing of the loan. The loan term and rate can either stay the same or change depending on the rates at the time, and only the loan provider is different.
Regardless of what you choose though, it is important to weigh the pros and cons of your final decision. To this end, it is important to consult with professional mortgage broker such as those at Clover Mortgage Inc., who can guide you in making the most optimal decision for you and your family.
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