How to 'break' a mortgage and not pay a penalty

About four years ago, I renewed my mortgage and locked in for a 5-year fixed term at an interest rate of 5.2 per cent because I was worried about rising interest rates. I realized a couple years later that I had made a mistake and considered breaking the mortgage to get a lower rate. The problem was that the penalty was very high and I didn’t want to pay it.

Instead, I used a different strategy which involves using my home equity line of credit to make lump sum payments against my fixed rate mortgage. Essentially, I converted my high interest fixed rate mortgage to a low interest credit line by paying lump sums borrowed on my credit line until my mortgage was gone.

Here’s how I did it:

The first step was finding out how big a lump sum payment I could make each year. I called my lender and discovered I could make $40,800 of extra payments per year, which was 20 per cent of the original value of the mortgage. Most mortgage companies offer some sort of pre-payment option.

The next step was to make use of our 3 per cent credit line to pay that $40,800. This step will be repeated every August, when a new “prepayment” year starts until the fixed-rate mortgage is paid off.

So on top of our monthly mortgage payment is a monthly interest payment for the credit line. In my case, it was $1,208 per month, plus $102 of interest for a total of $1,310. In year two, the credit line interest payments applicable to this tactic were $204. As you convert more of the fixed mortgage to the credit line, the interest payments will increase.

Here are the numbers;

In the first year, I converted $40,800 of a 5.2 per cent mortgage to a 3 per cent credit line and saved $893 in interest during that first year. Because my fixed rate mortgage payments remained the same, I was paying more principal with each payment which means the mortgage will be paid off faster.

In the second year, I moved another $40,800, and now had $81,600 added to the credit line. My interest savings in the second year were $1,786. In the first two years of this plan, we saved a total of $2,679 ($893 + $1,786) of interest.

But we had added $81,600 on the credit line which we intended to pay off once the mortgage was gone.

In my case, the mortgage wasn’t big enough to continue the huge annual pre-payments. I’ll be making the last prepayment this August for about $20,000 and that will be the end of our fixed rate mortgage.

As described, this method makes it sound easy. But the only reason we’re saving so much money is because the interest rate on the credit line is significantly lower than our fixed mortgage rate.

If interest rates rise – as they are expected to do this summer- so will my credit line costs and we will save less money. Worst case is that the prime rate rises above 5.2 per cent, at which point we will end up paying a higher interest rate on the credit line than on the fixed rate mortgage.

Another risk is lacking the discipline to pay off the credit line once the fixed rate mortgage is gone. A mortgage payment is amortized and is a blend of principal and interest. Most credit lines only require a payment large enough to cover the interest.

It becomes very easy to just make the minimum interest payment each month and enjoy the extra cash in your pocket. If you do this, your mortgage will never be paid off.

Once your fixed-rate mortgage has been completely converted to the credit line, you should make total monthly payments equal or larger than the amount you used to pay on your fixed-rate mortgage. This will ensure the credit line balance will get paid off in a reasonable amount of time.

Using a credit line to pay down your fixed rate mortgage can be a great way to save on interest costs. You have to be very disciplined and make sure you treat the credit line like a mortgage and make payments to the principal, once your fixed-rate mortgage is paid off.

Also read:

Why I paid $10,000 to break my mortgage 

How to reduce the pain when you break a mortgage.

Mike Holman is the author of The RESP Book and blogs about Canadian personal finance at Money Smarts.