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Rob McLister, editor of Canadian Mortgage Trends (Canadian Mortgage Trends)
Rob McLister, editor of Canadian Mortgage Trends (Canadian Mortgage Trends)

Decoding the mortgage market

What is mortgage flexibility worth? Add to ...

Canadian Mortgage Trends editor Robert McLister's third column for The Globe's month-long Home Buying site looks at mortgage flexibility.

In the car world it’s rare to find BMW performance at a Kia price. The mortgage world isn’t that different. Mortgages with the most capabilities typically cost more.

Fortunately, most folks don’t need a souped-up mortgage. They just need the right combination of options at a low rate.

In the quest for cost savings, things like refinance flexibility and prepayment privileges are often sacrificed for a cheaper rate. This is especially common when people can’t quantify how much a mortgage feature could save them.

But mathematically speaking, it is possible to estimate the benefit of mortgage flexibility. You can then decide if it’s worth paying for. It just takes some reasonable assumptions and a bit of light math.

In that spirit, here are some general estimates of what different mortgage features are “worth.” And by worth, I mean: how much extra a “typical” borrower should be willing to pay for a feature, in the form of a higher interest rate.

If 3.19 per cent is the lowest rate in the market, for example, a feature that’s “worth” 0.10 percentage points means that 3.29 per cent is probably a fair rate to get that feature. In other words, your total borrowing costs should be roughly the same in each case.

The values below are based on someone who has a 25-year amortization, a three-month interest penalty to break their mortgage early and a 50/50 chance they’ll actually use each feature.

Naturally, every borrower is unique. A given mortgage feature may be worth more or less, depending on one’s probability of using it, interest rates, financial resources, qualifications, and so on.

The standard closed term Most mortgages have standard “closed” terms, meaning you can end the mortgage before maturity simply by paying a penalty.

But some lenders dangle a tantalizing carrot: a lower rate in exchange for restrictive terms.

Restrictive terms prevent you from leaving a lender before your term is up – unless you sell your home. If you decide to refinance or upgrade your home before maturity, a restrictive term means you’re stuck with whatever rates your lender feeds you.

The worst case for someone with a restrictive term is when their lender refuses to approve them for a mortgage increase. The restriction on refinancing elsewhere leaves them with few options.

Consider this: Up to 70 per cent of borrowers break, end or renegotiate their mortgage before maturity. If there’s a reasonable chance you’ll refinance or buy a more expensive home, pay extra for a mortgage that gives you the option of escaping your lender.

What it’s worth: At least 0.10 percentage points (more if you have a large mortgage and much more if you have borderline qualifications).

A large lump-sum prepayment option (“prepayments” for short) Prepayments refer to how much extra you can pay each year – on top of your normal payments – in order to save interest and become mortgage-free faster.

Prepayments range from 0 per cent of the amount borrowed to 30 per cent. The higher they are, the more they cost your lender and (often) the higher your mortgage rate.

In reality, however, prepayments are greatly underused. Only 17 per cent of mortgage holders made lump-sum prepayments in 2011, according to the Canadian Association of Accredited Mortgage Professionals.

Of those who do make lump-sum prepayments, the total amount prepaid in a year averages 7.8 per cent of their mortgage. For that reason, 10 per cent lump-sum prepayments are usually good enough.

One exception would be if you expected to use a big cash infusion to pay down more than 10 per cent of your mortgage.

Large prepayments can also help reduce your penalty if you break your mortgage early.

What it’s worth: 0.05 to 0.10 percentage points or more depending on how much, how often, and how early into your mortgage you prepay.

Flexible portability When you move, portability lets you bring your mortgage with you, avoid a breakage penalty, and keep your low interest rate.

Most mortgages nowadays are portable, but some porting policies come with restrictions. For example, certain lenders force you to close your old home sale and new home purchase within 30 days or less of each other, which can be difficult to time.

Another restriction applies to local lenders, like credit unions. They often prohibit ports out of their lending area. So if you might move far away, a national lender is your best bet – unless your employer is reimbursing your breakage costs.

What it’s worth: 0.05 to 0.10 percentage points or more.

Mortgage increase flexibility Homeowners often increase their mortgage before maturity. That happens when people upgrade their home or withdraw equity.

If there’s a chance you’ll increase your mortgage, consider a lender that can “blend and increase” without a penalty. That means they will allow you to add a new mortgage portion without penalty or increase your mortgage without legal fees. Not all lenders will.

What it’s worth: At least 0.10 to 0.15 percentage points.

A good conversion rate Folks who plan to lock in their variable-rate mortgage should ask about the fixed rate discount they can expect. Some lenders leave this “conversion rate” policy up to your imagination. Then, when you go to lock in, you’re fed the lender’s standard rate, which is considerably above its best rate.

Choosing a lender that converts you to its best discounted rate can save big money.

What it’s worth: 0.10 to 0.20 percentage points.

It’s important to note that the above estimates are just that, approximations based on specific assumptions.

In the end, the most cost-effective mortgage is the one with the features you need, at a rate that’s not based on features you don’t.

Robert McLister is the editor of CanadianMortgageTrends.com and a mortgage planner at Mortgage Architects. You can also follow him on twitter at @CdnMortgageNews.

For tips, stories, videos and live chats about what's going on in the real estate market, check out the Globe's Home Buying section for daily updates.

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