When I get a call asking about refinancing a property, I always ask if you are presently in an open or closed term and will you have a pay out penalty if you leave your current lender?
Not all mortgages are alike and neither are all mortgage lenders. The penalty for breaking a variable rate mortgage is typically only three months interest while fixed-rate mortgage penalties are almost always calculated based on “the greater of three months interest or interest-rate differential (IRD)”. What you need to be aware of before you sign on the dotted line when first taking out your mortgage is there are key differences in the actual rates the many lenders use to calculate your IRD. Today the IRD calculations used by some prominent banks can trigger a penalty that is more than five times what you would be charged by a wide range of other lenders which us brokers call Mortgage Companies or Monoline Lenders.
Let’s start by assuming you have a current balance of $250,000 on a five-year fixed rate mortgage at 2.59%. We’ll also assume that you are three years into your term (with two years remaining) and that interest rates are the same when you break your mortgage as they were when you first got your loan.
Let’s start by quickly calculating the cost of three month’s interest:
$250,000 x .0259 divided by 365 x 90 days = $1,596.58
The IRD is where the calculations get tricky. It is the difference between the interest rate on the existing mortgage and the current standard, discounted or posted interest rate, for a mortgage term similar to the time remaining in the existing term.
Many people believe the differences in how lenders calculate fixed-rate mortgage penalties aren’t much of an issue now that rates are at all time lows, however, nothing could be further from the truth.
The relative cost of how penalties are calculated is never more pronounced than when fixed-mortgage rates stay flat or rise slowly over an extended period, which is what many experts predict will happen in the coming years. (You could be looking at an extra $7,000 in penalty cost on a $250,000 mortgage that is broken two years early.)
The Standard Rate IRD Penalty – When using a standard IRD penalty calculation, your lender starts by taking the difference between your contract rate (2.59%) and their current discounted rate that most closely matches your remaining term. As you have two years left on your mortgage, that would be the lender’s two-year fixed rate of say 2.29%. The difference between these two rates is 0.30%.
In this case the cost of three months’ interest is greater than the lender’s standard IRD calculation, so you would have to pay just the 3 months interest cost of the $1,595.58 to break your mortgage.
The Discounted Rate IRD Penalty- When using the discounted rate penalty, the lender takes your contract rate and compares it to the posted rate that most closely matches your remaining term MINUS the original discount you got from their five-year posted rate (which in this case is 2.05%).
In other words, this lender will take the discount they initially gave you from their five-year posted rate and apply that same discount to the posted two-year rate they use in your penalty calculation. The result makes a big difference to the cost of your penalty as the .30% difference detailed in the above example is now increased to 2.05%! Under this scenario the IRD will be charged as it is greater than the 90-day interest penalty
The Posted Rate IRD Penalty-In this variation, the lender calculates your IRD penalty using the five-year posted rate that they were offering when you got your mortgage.
The interest rate differential amount is the difference between the Interest on the current balance owing for the remainder of the term at the posted rate at the time you took out the mortgage and interest on the current balance owing for the remainder of the term using a comparable posted rate.
If we used the same rates in this example that we used in the discounted-rate method detailed above, the posted-rate method would result in the same sized penalty, however, some lenders posted rates tend to be higher than other lenders and for that reason, their penalties can be much higher.
I don’t have a problem with mortgage penalties in general because when you break a mortgage contract, your lender incurs costs when they in turn have to break agreements they have in place related to your loan (these agreements can relate to hedging, servicing or securitization). The penalty charged is to cover these costs while also recouping some of the lender’s lost profit. Reasonable enough as that’s why they are called “closed mortgages”. But is it fair for some lenders to use these early terminations as a way to “gauge” their clients?
I don’t believe the majority of mortgage borrowers have any idea that there are significant differences in the way fixed-rate mortgage penalties are calculated and the largest Canadian lenders, who have “banked” on that lack of awareness to their advantage for years don’t seem to be in any hurry to explain it to them.