Refinancing your mortgage in Canada: when it makes sense

What a refinance is

A refinance replaces your current mortgage with a new, larger one, and you keep the difference in cash. Debt consolidation, a renovation, buying out a spouse and a down payment on a second property are all ways to use that cash. The product is the same.

A refinance often gets confused with 2 other things.

A renewal happens at the end of a term. The balance stays the same, the amortization stays the same, and you either sign with your current lender or move to a new one. There's no penalty because the term has ended.

A second mortgage or HELOC sits behind or beside your first mortgage instead of replacing it. You keep the rate on your first mortgage, which matters a lot if that rate is low, and you pay a higher rate on the new money.

A refinance is the right tool when the amount is large, the purpose is long-term, and either your current rate isn't worth keeping or the penalty to break it is small.

The 80% refinance limit

A refinance is capped at 80% of your home's appraised value. That's OSFI Guideline B-20, and a regulated lender can't go above it. It also means a refinance can't be default-insured. Mortgage default insurance isn't available on a refinance at all.

The math is straightforward. A home worth $600,000 supports a refinanced mortgage of up to $480,000. If your current balance is $380,000, the most you can take out is $100,000 before costs.

This has 2 effects. First, the appraisal matters more than it does on a purchase, because it sets the limit directly. Second, a refinance is always priced in the uninsured tier, the most expensive of the 3 tiers on any rate board. If you're moving from an insured mortgage into a refinance at renewal, your rate may go up for that reason alone, whatever the market is doing.

Refinance penalties

If you refinance mid-term, you break your current mortgage and pay a prepayment charge. For most people, that penalty decides whether refinancing is worth it.

On a variable-rate mortgage, the charge is 3 months of interest. On a $400,000 balance at 4.20%, that's roughly $4,200. It's predictable, and it rarely changes the decision.

On a fixed-rate mortgage, it's the greater of 3 months of interest or the interest-rate differential (IRD). The IRD is where refinances go wrong, because lenders calculate it in very different ways. The big banks generally calculate it against their posted rate for the remaining term, after subtracting the discount you originally got. Monoline lenders and credit unions generally calculate it against the discounted rate you signed. On the same mortgage on the same day, the 2 methods can differ by 5 figures.

The safe way to handle this: ask your lender for the exact penalty in writing before you model anything. A calculator estimate, including ours, isn't enough. The written figure is usually valid for a short time, and it's the number to plan with.

How to work out your break-even

Once you have the penalty in writing, the math is the same for every refinance.

1. Add up your total cost: the penalty, discharge and registration fees, legal costs, and any appraisal the lender doesn't cover.
2. Work out your monthly saving. That's the difference between your current payment and the new payment on the same balance, at the same amortization.
3. Divide the total cost by the monthly saving. The result is your break-even, in months.

If the break-even is comfortably shorter than the time you'll keep the mortgage, the refinance pays for itself. If it's longer, it doesn't, however much better the new rate looks.

Keep 2 things in mind.

Keep the amortization the same when you compare. A new 25-year mortgage will always look cheaper per month than one with 18 years left. That difference is 7 more years of interest spread out.

Count the total interest as well as the payment. A lower payment over a longer term often costs more overall. Whether that's acceptable depends on why you're refinancing.

Good reasons to refinance

Consolidating expensive debt. Moving unsecured debt at 19% to secured debt at 4% is the most common reason a refinance pays off, and the drop in the monthly payment is usually large. Be clear about the trade: you're turning short-term unsecured debt into long-term debt secured against your home. The payment falls, the term gets longer, and the consequences of missing payments get much more serious. Have a plan to keep your credit cards at zero, or you'll end up with both debts.

Paying for a renovation that adds value. It's cheaper than a construction loan or a line of credit, and you get all the money at once.

Removing someone from title. In a separation, a refinance is usually how the buyout happens, and the 80% limit applies to it like any other refinance. Some lenders treat a spousal buyout more generously than a standard refinance, so it's worth asking about.

A large rate difference with a small penalty. This is rare mid-term and common in the last year of a term. The break-even calculation above tells you whether it's worth it.

Using a refinance to pay off other debt

On many files, the mortgage is the cheapest debt on the page. The problem is the $45,000 in lines of credit, credit cards and a vehicle loan beside it, at 3 to 5 times the rate.

A refinance is one way to deal with that, but it isn't always the right one. It doesn't work if the equity isn't there or the spending pattern hasn't changed. Sometimes a consumer proposal or a conversation with a licensed insolvency trustee is the better option. We'll tell you when that's the case.

If you want to see your numbers before you talk to anyone, try the refinance and debt consolidation calculators. They'll show you what a refinance would cost.