Clay Jarvis
Beth Buczynski
A mortgage refinance involves breaking your existing mortgage contract and paying the balance in full with a new loan. This new mortgage comes with its own terms, conditions, and interest rate.
Refinancing can turn home equity into cash or help you score a lower mortgage rate. It pays — quite literally — to know all you can about refinancing a home loan before starting the process with your lender.
How refinancing a mortgage works
Refinancing is similar to applying for a mortgage. Your income, debt service ratios and credit history will be evaluated again, and you’ll need to provide similar documentation. This can include:
- Identification.
- Proof of employment and income.
- Details regarding your assets, savings and debts.
- Tax documents.
You’ll also need a home appraisal to determine your property’s current value and undergo another mortgage stress test. The rate you’ll be stress tested at, also known as the minimum qualifying rate, will either be 5.25% or the rate your lender is currently offering plus 2%, whichever is higher.
How much can you borrow in a mortgage refinance?
The amount you can borrow when refinancing is determined by how much home equity you have.
You can typically borrow up to 80% of the appraised value of your home when refinancing, but you’ll have to use a portion of what you borrow to pay off your current mortgage balance. What’s left over can be spent however you like.
- Home’s appraised value: $500,000.
- Maximum refinance amount: $400,000. ($500,000 x 0.8)
- Current mortgage balance: $350,000.
- Pay off outstanding loan balance: $400,000 – $350,000.
- Cash left over: $50,000
What can a mortgage refinance cost you?
If you’re considering a mortgage refinance, be sure to budget for all the possible costs involved. A refinance might require paying:
- Legal fees.
- Title search and title insurance fees.
- Home appraisal fees.
- Mortgage discharge fees (if you change lenders).
When you add in prepayment penalties, a refinance could cost you thousands of dollars in upfront charges. You’ll also have to consider the extra interest you’ll pay if you extend your amortization. Understanding the full cost of a refinance can help you accurately compare it to other financing solutions, like a home equity line of credit (HELOC) or home equity loan.
Compare mortgage rates to save money on your mortgage refinance
Top reasons for refinancing a mortgage
There are two main reasons why you might want to refinance your mortgage.
1. To secure lower borrowing costs.
Refinancing can be a way to secure a lower mortgage interest rate, a longer amortization period or new conditions that might allow you to repay more of your mortgage ahead of schedule. Each of these changes can lead to lower short- and long-term mortgage costs.
When refinancing to get more attractive loan terms, you don’t necessarily have to pull out any of your equity.
2. To free up cash.
A refinance also gives you the option of accessing any money left over after paying off your previous mortgage. This could be tens, or even hundreds of thousands of dollars, depending on the value of your home and how much equity you have.
Nerdy Tip: Keep in mind that a desire for lower borrowing costs or freed-up cash flow doesn’t mean that you should refinance — everyone probably wants those things! One Reddit user on r/MortgagesCanada posted they were considering refinancing as a way to fund a screened-in porch.[1] Another Reddit user posted in r/PersonalFinanceCanada they might refinance as a way to raise cash to replace a failing car and pay off debt.[2] While both people are looking for a way to raise cash, whether it’s a good idea depends on factors such as their income, other debts and funding alternatives available. For one person, it could make sense. For another, it may not.
When is the best time to refinance your mortgage?
Refinancing your mortgage will provide the most benefit when:
- Mortgage rates have fallen enough that the money you save will be significantly greater than the prepayment penalty you’re charged.
- You need money to make a major purchase or investment, or pay off debt, and the refinance rate is lower than what you’d be charged using a HELOC, credit card, personal loan or line of credit.
Refinancing for other reasons may not be the best use of your home equity.
Ideally, you want to use your equity to strengthen your household finances. Once you realize those benefits and have more breathing room in your budget, you can use the money you’re saving to fund lifestyle spending or other discretionary purchases.
To determine if the time is right to refi, ask yourself (and your lender) the following questions:
- What’s my existing mortgage rate versus current mortgage refinance rates?
- What are the administrative costs and closing costs associated with refinancing this mortgage?
- How will I benefit from using my equity?
- How much is the penalty for breaking my mortgage?
- Is there a better way to pay for a major purchase?
Reducing prepayment penalties when refinancing
Deciding whether to refinance your mortgage mid-term often comes down to whether the benefits outweigh the penalties.
Paying off your mortgage early means incurring a prepayment penalty. To minimize this penalty, the ideal time to refinance is generally near the end of your mortgage term, especially if you have a closed, fixed-rate mortgage.
If you refinance a closed mortgage ahead of schedule, your prepayment penalty will likely be based on your lender’s interest rate differential (IRD), a calculation that helps them recoup some of the interest they’ll be missing out on. IRD varies from lender to lender, but it typically results in higher penalties than those charged on open or variable-rate mortgages.
The penalty on a variable-rate mortgage isn’t as steep. It’s typically three months’ interest.
Refinancing can provide a significant boost to your household finances.
Pulling out equity can help you pay down debt or make a major investment, like a second home or post-secondary education. If it helps you obtain a lower interest rate, refinancing can immediately improve your cash flow, too.
Refinancing can be particularly useful if you have a variable-rate mortgage. If variable rates increase significantly over your term,refinancing might allow you to switch to a lower fixed-rate mortgage and secure a more stable rate without being penalized.
But there are instances where refinancing may not be the best move.
If prepayment penalties will devour a significant portion of the proceeds, for example, you might be better off waiting until the end of your term and seeking out a better deal when you renew your mortgage.
If you refinance to extend your amortization period, you might secure lower payments, but you’ll be paying interest for several additional years and adding thousands of dollars to the cost of your mortgage.
Pros:
- Saving money by getting a lower interest rate.
- Freeing up cash flow by arranging smaller monthly mortgage payments.
- Accessing funds that can be used on major purchases or debt consolidation.
Cons:
- Winding up with a longer mortgage.
- Having to pay penalties or other fees.
- Paying a higher interest rate than if you waited to renew.
Nerdy Tip: When refinancing, it’s important to do some comparison shopping to ensure you’re getting the best rate, terms and conditions. You don’t have to refinance your mortgage with your current lender, so compare several before deciding which one offers the best deal. If you stick with your lender for your refinance, remember to negotiate a better mortgage rate.
Explore your options: Alternatives to mortgage refinancing
| What it is | Pros | Cons | |
|---|---|---|---|
| Blend and extend | Extending your existing mortgage contract by blending a new, lower interest rate with your current rate. | You can take access falling rates without breaking your mortgage and paying prepayment penalties. | Not always an option. If you extend your term longer than you stay in your home you’ll pay prepayment penalties. |
| Home equity line of credit | A secured, revolving credit line that allows you to borrow up to 65% of your home’s market value if you have at least 20% equity. | No need to break your mortgage. Application process can be shorter if you’re dealing with a familiar lender. | You must pass a stress test. HELOC rates are generally higher than refinance rates. |
| Home equity loan | A second mortgage typically offered by non-chartered banks or private lenders. | No prepayment penalties. Many providers to choose from. No mortgage stress test. | Rates can be significantly higher than with a refinance or HELOC. Borrowing from a private lender carries unique risks. |
Frequently asked questions about mortgage refinance
If a mortgage refinance involves extending your amortization period, you’ll be paying interest on your mortgage for several additional years. Breaking your mortgage early to refinance can result in hefty prepayment penalties.
A mortgage refinance can negatively impact your credit. You’ll undergo a hard credit check, which will lower your credit score temporarily. Closing a mortgage and replacing it with a new one may reduce the overall length of your credit history, which can also impact your credit score.
There is no limit on the number of times you can refinance a mortgage in Canada.
Refinancing a mortgage involves breaking your current mortgage contract so you can sign a new, more beneficial one. You might refinance to get a lower mortgage rate or to turn your home equity into liquid cash.
Article Sources
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Reddit, “Renovations – should I look at refinancing mortgage?,” accessed September 9, 2024.
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Reddit, “Refinance now or wait for renewal?,” accessed September 9, 2024.
About the Author
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