Q: I am recently engaged and my fiancé and I each own a house. We are looking to sell both and buy something together with the equity in order to have a shorter mortgage.
We each have 22 years left on our mortgages and two years left on our current mortgage term. There are many things to consider such as real estate commissions, land transfer tax, refinancing/interest rates, discharging and porting fees. It’s hard to know where to start! We really want to be mortgage-free sooner and pay less interest in the long run; that way we have more money to invest in savings each month. How do we calculate if the fees are worth the move? How do we decide what our budget for our new home is?
A: Hi Jamie. Congratulations! It’s great that you and your fiance are deciding to “officially” tie-the-knot and, even better, that you are thinking about your financial state of affairs and planning accordingly.
Before getting started, I think the overall plan—to sell two smaller properties and buy a larger property, while reducing mortgage debt—is a very smart approach to becoming mortgage-free sooner. But, as you surmised, there are many factors involved in determining whether or not to proceed. In fact, there are three factors to consider. Let’s take a look at each, separately.
No. 1: Mortgage penalty
Most, if not all, lenders will charge you a fee for breaking your mortgage early. Essentially, this is a fine, otherwise known as a penalty, for breach of contract. “What?” you ask. Initially, you agreed to borrow money from your lender for a certain period of time — say five years. The lender calculates their business projections based on these contracts. Now, if you break the contract — end your mortgage early — you are in breach of contract. To compensate the lender, you pay a penalty. It’s standard contractual law.
This isn’t such a bad deal if you and your fiance initially opted for a variable rate mortgage. The penalty to break a variable-rate mortgage is the sum-total of three months’ worth of interest, plus any legal fees incurred for disposing of the mortgage (which are typically anywhere from $100 to $1,000). So, if your mortgage payment is $1,300 per month and $650 goes to interest, your total penalty would be roughly $1,950 (plus legal fees).
The penalty calculation gets far more complicated if you or your fiance opted for a fixed-rate mortgage. Penalties on fixed-rates are calculated using the Interest Rate Differential (IRD) formula. This formula is unique to each lender, but typically the formula is based on three factors:
The amount you are pre-paying (if you are selling your home then technically you are pre-paying the entire outstanding mortgage loan);
The interest rate equal to the difference between your original (usually discounted) rate and either the rate a lender could charge today for the same type of loan or the posted rate for that same mortgage;
The length of time before the mortgage contract was to expire.
For simplicity, let’s use the RBC IRD penalty calculator (found here). Let’s assume you owe $350,000 on your mortgage and, as you stated, you have two years left on the fixed-rate term. Your discounted mortgage rate is 3% and you received a 2% discount off the bank’s posted rate. Based on all this information, your penalty for breaking the mortgage early would be closer to $8,125. Now, multiply that by two (since you aim to sell two properties, which means breaking two mortgages).
That’s pricey. Worse still is that a small number of lenders simply prohibit any borrower from breaking the mortgage early, unless you can officially prove the completed sale of the property. To be sure, always contact your lender directly for an exact penalty quote and for all restrictions and rules.
There is a chance you can save money by porting one mortgage to the new property, but that’s not always an easy solution. For the most part, lenders will still charge a fee to port a mortgage and, typically, you can only port the existing amount owed on the mortgage debt. So, if you still owe $310,000 you’d be able to port that amount to your new property. If your new property cost you $750,000 and you were able to sell the second condo, pay all fees and net $300,000, you’d have to get a loan of $450,000 to afford that property. Since you’re only able to port $310,000 from your old mortgage, you’d have to get additional financing for $140,000. This may or may not be a problem depending on whether or not this new loan is considered part of your initial loan (the lender extends the mortgage amount) or you have to get a second mortgage. Keep in mind that in both circumstances, you probably won’t get the preferential interest rates, so the added cost of more interest should also factor into your long-term calculations.
Potential Cost: $1,950 to $16,250
No. 2: Transaction Costs
Then there are the transaction costs for buying and selling real estate. These are the costs buyers and sellers incur whenever property changes ownership and include: real estate commission fees, legal fees, moving fees, utility connection fees as well as Land Transfer Tax.
Again, for the sake of simplicity, let’s assume you and your fiance live in Metro Toronto and plan to sell two condos in order to buy a house. As a seller, you will be responsible for paying the Realtor commission on your condos, but not on the house you purchase. Without trying to negotiate a better rate (for example, by agreeing to use the same agent for the sell and buy side), you and your fiance would have to pay $35,000 in real estate commissions (assuming 2.5% to the buy-side agent, 2.5% to your listing agent, based on the sale of two condos priced at $350,000, each).
Potential Cost: $17,500 to $35,000
Then there are legal fees. Most straight-forward property sales will result in legal fees between $800 and $2,000. For the full potential cost, you need to multiply this by three (selling two properties to purchase one).
Potential Cost: $800 to $6,000
Now add in the Land Transfer Tax. In Toronto, you’ll be hit twice with this tax (a municipal version and a provincial version) and the total cost is based on the registered purchase price of your property.
For the sake of our example, let’s assume you buy a house for $750,000. You’ll have to pay $22,950 in LTT on that purchase. If you were a first-time buyer you would’ve been eligible for an $8,475 rebate, but you’re not.
Potential Cost: $22,950
Finally, there are the incidental moving costs. Typically, I find the incidental costs (not including legal and real estate fees) amount to about 0.5% of the purchase price. In our example, this means setting aside about $3,750 for incidental moving costs.
Potential Cost: $3,750
No. 3: Mortgage interest savings
The final piece of this puzzle (aside from the emotional desire to buy a home you and your fiance can grow into) is how selling two properties to get a bigger down payment will impact the overall cost of buying a bigger property.
Based on our assumptions, you buy a $750,000 home. Let’s assume selling the two smaller properties gives you and your fiance $100,000 for a down payment (after all other expenses are paid). You use $77,050 as a down payment (setting aside $22,950 to pay for LTT).
Since you’ve put less than 20% down as a down payment, you’ll need to tack on mortgage default fees. Based on this down payment this fee will be around $21,000. Assuming you tack it onto your mortgage, you will now have a mortgage debt of $693,950. Let’s assume excellent credit scores for both you and your fiance and you secure a five-year fixed rate at 3.5% over a 25-year amortization. Your monthly mortgage payment will be roughly $3,465. I know, ouch.
If you didn’t sell your two properties and relied on just savings for a down payment you would increase your mortgage default fees to $28,000, which would add to your overall mortgage debt and increase your monthly payments to $3,501.
Put another way, you cashed out on two properties, to theoretically buy a larger property with a bigger down payment and to reduce your overall mortgage debt. By doing so, you reduce your potential monthly mortgage cost by $36 per month. Over five years that’s a savings of $2,260.
Potential Savings: $2,160
Let’s sum it up
In the end, your aim is to reduce your mortgage debt. For many, the smart way to do this is to consolidate debt. In this case, selling two properties to buy one effectively consolidates the mortgage into one debt owed.
The problem with this assumption is that it does not take into consideration the transactional costs of real estate purchases and, as you can see, these transactional costs can be high. Very high. It’s one reason why in almost all cases, I’d advise property owners to not even consider selling until they’ve owned the property for at least three years (the typical break-even point) and as many as seven years (where you actually begin to see significant equity in the property).
While I’ve made a number of assumptions to illustrate your situation, we can see from these very typical assumptions that to save about $2,100 over the next five years, you and your fiance may end up spending between $46,950 to $77,950. Double Ouch.
Now, if you want my advice (and hey, you get what you pay for and, in this case, it’s free), I’d look for a mortgage broker that understands the pros and cons of holding real estate investments. Talk to this broker about the potential costs and savings if you were to sell the two properties you and your fiance own individually (and use that money as a down payment on a new home) or if you could hold the two properties, purchase a third and then consider selling in the future, when the equity in the two, initial properties would more than make-up the transactional costs.