MORTGAGE PENALTIES – EESH! WHAT A PAIN IN THE ….!!
I am not sure how this is with other brokers, but for myself, I rarely get asked about mortgage penalties when arranging mortgages for clients. Many do ask about pre-payment privileges, which is also important, but not about what happens if they have to pay their mortgage in its entirety prior to term. I am not sure why. I guess it’s the belief that they will have no reason to break their mortgage early or perhaps they are so caught up in the excitement of purchasing or refinancing. Of course, we go through this with clients at commitment stage, but even then, it rarely becomes a focus of attention.
However, mortgage penalties have a huge impact on your overall borrowing cost. Did you know that on fixed rate mortgages, the cost of breaking an mortgage early can be as much as 5 times higher from one lender to another? Yes, I know, no one “plans” to break their mortgage early. But life happens and a large percentage of us need to break our mortgage early for one reason or another. So, borrowers must incur these costs and it can be very painful.
So what’s really going on with penalties and how are they calculated. Well, most institutions use the typical Interest Rate Differential method (IRD), which for basics is “the greater of three months interest or interest rate differential”
The problem with this is that every lender may use a different rate or base in the IRD calculation. This is what will cause the difference in penalty from one lender to another.
There are three basic methods used by lenders to calculate IRD penalties. They are Standard, Discounted or Posted.
The lender will take the difference between your contract rate and their current rate for the term that most closely matches the time remaining on your term. So if you have 2 years (24 months) remaining on your 5 year term, the lender will use their current 2 year rate to calculate the IRD. Assume your rate is 2.79 and the 2 year rate is 2.29, the rate differential would be .50%.
The difference between these two rates is multiplied by both the existing mortgage balance and the time remaining on your mortgage (in this case, 24 months) and divides it by twelve.
Based on this calculation, the lender will determine if 3 months of interest is higher than the IRD calculation, and your penalty will be determined.
Say it isn’t so, but the discounted rate is not “really discounted”. Many of the major banks use this method. What happens here is that the lender uses your contract rate and compares it to the “posted” rate that most closely matches the term remaining on your mortgage. From there, they subtract the discount you received on your mortgage at inception.
Advantage, lender. Why? Because large discounts on 5 year posted rates are normal. So, when you get your mortgage, you feel proud and special to have received such a large discount from the posted rate. For example, today’s posted rate is 4.74 for a 5 year term, and standard bank 5 year discounted rates are 2.69, with even lower rates available. That’s a 2.05% discount. Sounds great, doesn’t it?
Not really. For example, the 2 year posted right now is around 2.84. Based on this, your discount would be deducted from the posted rate, so 2.84 less 2.05% discount, gives you a rate of 0.79%, making the IRD a full 2.0% rather than the .50% in the standard calculation. Huge difference.
This is one I have seen and without naming lenders, the worst, for the borrower.
This one simply takes the 5 year posted rate at the inception of your mortgage and uses the current posted rate for the term the most closely matches the time remaining on your mortgage. So, you are charged to full difference between the two rates for the term remaining.
First, let us all understand that when you break a contract early, there should be a built in penalty, so no argument here. It is after all a “closed mortgage”. However, the question is do you want to be in a position to pay for the interest lost by the lender to pay your mortgage off early, or would you rather be in a position to pay for the interest lost and make a nice extra profit for the lender?
There is no issue with choosing to go with a lender that uses an IRD method that may be more expensive for you (if you need to break your mortgage early). This issue becomes in knowing what you are up against at inception, not when the time comes, as that could be a nasty surprise. Make this part of your mortgage process at inception, and avoid these surprises.
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