MORTGAGE: The perfect mortgage

The perfect mortgage is, of course, no mortgage at all. So, the next best thing is to have one flexible enough to pay off the principal as fast as possible.

All mortgages are structured so payments in the early years are primarily interest charges: Very little principal is shaved off unless you make sure payments are high enough and frequent enough that a good chunk -- perhaps 50% rather than the usual 5% or 10% -- is going straight to the principal.

Taking advantage of annual prepayment options, usually 10% or 15% of principal, is another way to chop years off an amortization schedule and save tens of thousands of dollars in interest payments.

Couple this approach with interest rates hovering near generational lows, and home buyers have a real opportunity right now: Someone taking out a fixed-rate mortgage may be paying as little as 3.69% in interest, which means even more of the monthly payments will be whittling down the principal.

But what about those who committed to fixed-rate mortgages when rates were higher? It may now be worth their while to break the existing mortgage and refinance.

The problem is homeowners have no legal right to break the contract, said Toronto real estate lawyer Alan Silverstein, who once wrote a book titled The Perfect Mortgage.

If you have a 10-year mortgage, after five years you can break it by paying a penalty of three months interest.

But for mortgages of less than five years, there's no law saying the homeowner has the right to pay off the mortgage and refinance under more favourable terms.

At most institutions, the penalty is the greater of three months interest or the Interest Rate Differential (IRD).

The latter is the difference between the higher rate you had originally agreed to pay and the lower rate institutions would now be able to charge by lending the same capital to someone else.

A deal's a deal, after all, and the lender would lose a bundle by letting you off the hook.

Even so, TriDelta Financial president Ted Rechtshaffen suggests refinancing now could save homeowners "thousands." "Do not be put off by what looks like a big penalty. It is only one factor," he says.

"These penalties can also be rolled into a new mortgage so you don't have to come up with the cash." The first step is to read your mortgage contract to find out what it will cost to refinance. It may be a wash -- what you gain in lower interest charges may equal the penalty. However, if you're convinced rates will continue to fall, it may be worthwhile.

You can find out the IRD precisely with a $19 calculator from Burlington, Ont.-based Amortization.com. The developer, Ron Cirotto, uses the example of someone with a $300,000 five-year fixed mortgage at 6%, amortized over 25 years. It was taken out two and a half years ago, so it has 30 more months to run. Monthly payments are $1,919.42. The new fixed mortgage rate is 4%, and the IRD is $13,663.

Say the homeowner decides to stand pat and not pay the IRD, and a month later rates drop 0.25%. It will cost even more to break the contract, which now has 29 months to run. The IRD jumps $1,260 to $14,923.

"The difference between the old rate and the new one is the main driving force for the IRD," Mr. Cirotto says.

John Andrew Newman, an agent with Mortgage Intelligence in Mississauga, Ont., says refinancing makes sense if your income has changed or you're relocating. But to refinance solely to get a lower rate is not always advisable, he says.

Finance professor Moshe Milevsky says it may be a wash near the start or end of an amortization schedule, but there may be a sweet spot -- perhaps with two years to run -- where it pays to refinance.

The decision resembles that involved in deciding to stay short with variable-rate mortgages: Homeowners need to consider cash flow and household balance sheets.

First-time homeowners shouldn't speculate and if they can't handle the cash flow if rates rise on a variable mortgage, they should lock in with more predictable fixedrate mortgages.

Personally, having carried a very imperfect mortgage at 11.75% in the late 1980s, I'd have been ecstatic to lock in at today's fixed rates. From that vantage point, even today's 10-year fixed rates of 5.15% look perfect.

- Jonathan Chevreau is the author of Findependence Day and blogs at www.wealthyboomer.ca.

(prepared by Jonathan Chevreau/Vancovuer Sun)