Your Mortgage Penalty

Someone recently asked if I could describe the various ways in which your mortgage penalty is calculated.

Generally speaking, lenders usually use a 3 month interest penalty, or an Interest Rate Differential penalty (IRD). The penalty for breaking a fixed rate mortgage is usually the greater of 3 months interest, or the IRD (in some cases when it is very close to maturity, the 3 month interest penalty will be higher, but otherwise the IRD penalty is much higher than 3 months interest).

Variable rate mortgages usually use the 3 month interest penalty. Some variable mortgages offering lower rates, however, will use an IRD or, in some instances, are closed (you cannot break them) without a bona fide sale of the property. This is also the case for some niche fixed rate mortgage products.

It is in the IRD penalty where there can be vast differences from one lender to another.

The IRD penalty is based on 3 things:

  • The principal balance of the mortgage at the time you break it
  • The difference in the interest rate of the original mortgage and the rate the lender would charge for the term closest to the remaining time on the mortgage (for instance, if there are 21 months left, the lender will most likely use their 2 year term interest rate as the comparison rate).
  • The number of months remaining in the mortgage term.
  • If the lender uses the discount off the posted rate in the equation, it widens the difference with the comparison rate. This increases the IRD penalty.

    AN EXAMPLE

    Let’s take these 2 examples on a 5 year fixed mortgage:

    Mortgage Amount: $300,000
    Current Interest Rate: 2.69%
    Discount Originally Obtained From the Posted Rate: 1.95%
    Months Remaining on the Term: 22
    Lender’s Comparison Rate: 3.04%

    Let’s say one lender uses posted rates to calculate their IRD (and many lenders do). The differential here is 1.6%. The penalty would be $8,800.

    Now, as a comparison, another lender uses only contract, or effective rates, to calculate the IRD (and there are many lenders who do). Therefore, the discount is not applicable, and the comparison rate for a 2 year (using today’s contract rates) would be around 2.19%. The differential would be 0.5% and the penalty would be $2,750.

    In each case, the 3 month interest penalty would be $2,018. But the different IRD calculation has inflated the penalty for the first lender.

    BIG BANK STRATEGIES

    One strategy the big banks have used over the past few years is to register liens on homes as collateral charge loans, rather than as mortgages. The advantages of this is that it allows the buyer to refinance at minimal, or no cost any time during their term. The caveat is, because it is a collateral charge loan rather than a mortgage, the client cannot leave that financial institution, even at the maturity date, and needs the services of a lawyer or title insurance company to break the loan agreement with that financial institution. This costs several hundred dollars. The financial institutions using collateral charge loans are aware of this cost and can afford to offer an interest rate at renewal that is a higher one, closer to a posted rate, rather than the discounted rate offered by their competitors, since the client does not want to incur this extra cost.

    So, when mortgage shopping, it is always good to look at not only the interest rate, but also:

  • Confirm if there are prepayment privileges, or if it is a totally closed mortgage (except for a bona fide sale)
  • How that lender calculates their IRD penalties when breaking a mortgage
  • Their pre-payment privileges (could be 15%, 20%, or 25%)
  • Whether the interest is calculated monthly or semi-annually (this can mean up to a few hundred dollars per year you are paying extra if it is monthly)
  • We are the only mortgage service in Ontario that provides a full estimation of mortgage penalties when you are applying for a mortgage, so you can see the hidden costs buried in your mortgage agreement. Get your free quotes, including penalty calculations, in just 90 seconds at: http://www.GTAMortgagePros.com/Apply-Now