Ok, let’s talk about mortgage interest for a moment. Because now that it is historically low, you may be wondering if A lower mortgage rate is an option and if you can transfer your current rate to this low rate without having to buy a new home right away.
The short answer is, yes that is often possible with your own mortgage party. But note that this can vary from party to party, so be sure to find out how this works with your mortgage lender. When you switch with your own mortgage lender, the loan will remain as is and you will pay a different interest rate on that loan.
If you switch mortgage lenders, you take the remaining loan with you to an entirely new party.
In this example, we’ll show you how it works if you stay with your current mortgage lender and switch interest rates.
Pst, would you like to read more about mortgages? Then check out this page of other mortgage articles!
A lower mortgage rate, how does it work?
Then again, what do you do when you go to refinance interest?
Example: Suppose you have a mortgage of €200,000, with a term of 30 years and an interest rate of 3%, you pay €6,000 per year in interest (200000 x 0.03). So suppose you can lower your interest rate to 1.5%, then you will pay only €3000 a year. Quite a difference.
(In this calculation example, we do not consider a linear or annuity mortgage, purely for illustration purposes we use an installment-free mortgage).
Sounds good, you will have to pay less interest on your mortgage amount. But your mortgage lender is a little less happy about this, because they will get less interest income from your loan. That’s why you can’t simply refinance your interest rate.
Penalty interest
The mortgage lender is basically saying to you “hoho, we have an agreement, you would pay me this interest rate for 10 years. So the mortgage lender charges penalty interest.
In the following example, we have explained as clearly as possible how that interest is calculated. In addition, we also calculate how the tax benefit of penalty interest is calculated.
Example:
Suppose you have a €200,000 mortgage at 3% interest and a 10-year term. 5 years have passed and you have 5 more years to go. So for the past 5 years you have paid €6,000 in interest every year, and you now want to go to a new interest rate of 1.5%, with therefore another 5-year term.
Briefly:
Original principal amount: €200,000
Remaining loan: €180,000
Current interest rate: 3%
New interest rate: 1.5%
Remaining term: 60 months ( 5 years )
Percentage redemption without penalty: 10%
Fine on what amount?
First, you calculate on what amount you actually have to pay the penalty. Because part of it you may repay without paying penalty, so when penalty interest is charged, it may only be on the amount you actually pay penalty on.
The remaining amount is €200,000 of which 10% is penalty-free, so €20,000. This means that the amount on which penalty is paid is €200,000 minus €20,000, i.e., €180,000.
Difference in interest
Ok, then let’s look at the difference in interest rates. This is where you have to pay attention, because the mortgage lender compares with an interest rate similar to the remaining period. So in this example, there are still 5 years to go, so the mortgage lender is charging that interest rate.
You’ll often see a list at a mortgage lender that looks like this.
1 year fixed: 1%
2-year fixed: 1.3%
3-year fixed: 1.4%
5-year fixed: 1.5%
10-year fixed: 2%
20-year fixed: 2.5%
*Note, percentages are fictitious this is just an example.
Since the example talks about a remaining period of 5 years, then the mortgage lender compares it to the interest rate they charge for 5 years, in this example 1.5%.
What does a mortgage lender miss out on?
The next step is to look at interest they are missing out on. You go from 3% to 1.5%, so they miss out for 5 years, 1.5%, because 3% minus 1.5% = 1.5%.
They then calculate 5 years x 1.5% = 7.5%
And then the penalty interest is €180,000 x 7.5% = €13,500.
Cashing the fine
A considerable amount, then, it is important that the mortgage lender makes “cash. But this is not yet the penalty interest. Because you now pay the amount in 1 lump sum and you get a kind of “discount” on that. For this example, it comes out to an amount of €13,275. The formula to calculate this = Current Value = Future Value / (1+interest rate per month)^number of months.
But honestly, we calculated this in a calculation tool. In short a lot of steps later we found out that the penalty interest in 1 time €13,275 is.
Tax benefit of penalty interest
You may deduct this penalty interest from the IRS, because yes, you may do the same with mortgage interest if you pay it per month. You may deduct this from your taxable income, and so depending on the amount of your income, you pay a percentage tax on the remaining amount. So this can be 52% in the highest incomes.
Example:
Your income is €50,000, then you fall into the first tax bracket of 37.1%.
So in an ordinary year you pay 37.1% of your income in tax that is €18,550 in tax.
Now you pay the penalty interest and your taxable income is €50,000 minus €13,275 in penalty interest. That means your taxable income is now €36,725 and you pay 37.1% tax on that, which is €13,625.
So without penalty interest you pay over 18 thousand euros and the penalty interest creates almost 5000 euros of tax paid.
So your net penalty interest is then: €8,349.
But is it attractive to over-lose now?
Let’s see.
In the old situation, you pay interest in 5 years:
€200,000 x 3% x 5 years = €30,000.
In the new situation, you pay:
€ 200,000 x 1.5% x 5 years = € 15,000 + € 13,275 penalty interest – € 4,925 less tax = € 23,350
So there is a difference of €6,650 in favor of switching interest rates. But so calculate this carefully for yourself.
What are the drawbacks?
Yes, you do have to have the money to pay the penalty interest and the patience to include it in the following year’s tax return to receive the tax benefit.
And in this example you’re fixing the interest rate for 5 years, so what happens after those 5 years, maybe the interest rate will be over 3%, that’s a risk.
So you can also choose to fix the interest rate for a longer period than 5 years when interest rates are low. The calculation then remains the same, but you fix it longer. Then the risk is that the interest rate is lower after 5 years (remaining term) and so you inadvertently fixed the interest rate for a long period when it would have been lower if you had just let it go. Anyway, so usually there is also a benefit to switching although you have to calculate that yourself.
This calculation does not assume a straight-line and/or annuity mortgage. Because you are already paying off monthly in that, the calculation is slightly different. Often your mortgage lender can show you exactly how they do the calculation.
