Consider the Penalty on a Discounted Mortgage Rate
By Alisa Aragon-Lloyd, as seen in “New Home + Condo Guide” magazine, April 2nd, 2022.
Even though mortgage interest rates have increased, they are still at historical lows. So, when you look for a new mortgage, it is important to see beyond the rates being offered and pay attention to how much it will cost you to break your mortgage.
Why Would You Need A New Mortgage?
Even though you may have planned to live in your home for the term of the mortgage, life events can get in the way. Perhaps you will need a larger home as your family grows or an opportunity arises to move to another city for a new job. Or, maybe you want to take equity out of your home, you end up divorcing or there are health reasons involved. The penalty to get out of your mortgage early will vary depending on the type of mortgage that you have and the lender that holds your mortgage.
Your lender will consider two variables to determine the amount of the penalty you will pay: is your mortgage a variable rate or a fixed rate? If you are in a variable rate, the maximum you would pay most likely is a three-month penalty interest. However, if it is a fixed mortgage, you will pay the greater of either the interest rate differential (IRD) or the three-month interest.
Interest Rate Differential
The IRD is calculated by determining the difference between your current mortgage rate in effect and the rate available at the time of the prepayment, multiplied by the term remaining on the mortgage. The interest rate differential is meant to compensate the lender for having the mortgage paid early. Most lenders have different ways of calculating their pre-payment penalties, therefore, it is critical that you find out how they will be calculated upfront before signing your mortgage, even more so if you think you might need to get out early.
How The IRD Can Have A Huge Impact On What Your Penalty Will Be
A client was looking to refinance their mortgage as they wanted to take equity from their home for investment purposes. Their current mortgage was held by one of the big banks. When they signed their original mortgage, the bank had offered them a discounted rate of 2.99 percent and their mortgage was up for maturity in July 2024. One would think that the interest rate differential penalty might be considerably low because of the effective rate of 2.99 percent. However, the rate of the original mortgage was discounted from 5.34 percent (posted rate at that time). Therefore, it was 5.34 percent that was used when the IRD penalty was calculated. To the surprise of the clients, instead of paying $3,813 in penalty, they had to pay more than $24,000 to break their mortgage with the bank. From the example above, you can see that as mortgage interest rates are still low, the posted rates offered by the big banks have remained much higher. That means if you receive substantial discounts from the posted rates, it can work against you when calculating the interest rate differential when a big bank determines how much the penalty would be to break the mortgage. There are monoline lenders (lenders that only work with mortgage experts) and there are many who use the contract or effective rate when they calculate the IRD penalty
on a fixed rate mortgages, unlike the banks. Since they use the actual contract rate, the penalty would have been much lower for the clients mentioned above.
A Money-Saving Solution
In Canada, six out of 10 households break their existing five-year fixed term at the 38-month point. This leaves an average of 22 months’ penalty against the outstanding balance. With a mortgage of $300,000, the penalty would be approximately $15,337 from a bank. The very same mortgage with a monoline lender would be about $3,788. This is a savings of $11,549. Whether you are dealing with a mortgage expert or your bank at the time of negotiating your mortgage, you should have them walk you through the penalty calculation so that you fully understand how much it will cost if you need to get out of your mortgage early. If you are not happy with the mortgage that you are presented with, you can walk away before signing and find an option that you are comfortable with. Focusing on the rate may save you a few dollars on your monthly mortgage payments, but if you don’t pay attention to the penalty fees, it could end up costing you thousands of dollars more if you have to get out of the mortgage early. A mortgage expert will develop a financial strategy to find you the best mortgage options and guide you throughout the decision-making process to ensure that you consider your current situation and make sure you look at future scenarios as well.