In addition to looking at interest rates, one should also consider the cost of paying out a mortgage early.
Generally, lenders will allow you to make a lump sum payment each year equal to a certain percentage of the original mortgage balance and to increase your regular payment by a certain percentage each year. How much is dependent on the individual lender.
If you prepay your fixed rate mortgage by more than that allowed by your lender, you will be subject to an interest penalty, usually the greater of a) 3 month interest or b) interest rate differential (IRD). With a variable rate mortgage, the penalty clause is usually only 3 month interest.
The concept behind IRD is that you will have to pay the lender for the loss of interest income when you break your term early, ie, the difference between what the lender would have received if you kept the mortgage for the entire term and at what rate the lender can now lend the funds.
Example:
You took a 5 year 3.79% interest rate 3 years ago. You were happy with this as your lender gave you a special discount of 1.35% off their posted rate of 5.14%. The current 2 year rate is 2.89%. You now decide to pay out in full your mortgage of $150,000.
IRD is calculated as: (mortgage rate – rate at which lender can now lend out funds) x outstanding mortgage balance x term remaining
Some lenders will use your contracted rate to calculate the interest penalty: = (3.79% – 2.89%) x 150,000 x 2 = $2,700
Other lenders will also factor in the 1.35% discount that you received, essentially basing the interest penalty on the posted rate at the beginning of the term: = [3.79% – (2.89% – 1.35%)] x 150,000 x 2 = $6,750
Similarly, if you received any cash back or other financial incentives for your mortgage, the lender may also claw the incentives back, either in full or a percentage based on how long you stayed in your mortgage term.