It’s impossible to plan on many of the unexpected things that life can throw at us; job loss, illness, divorce, or as we’ve seen recently with a global pandemic like Coronavirus (COVID-19). There are many reasons why you may need to break your mortgage early, and while it’s not something you plan for when you first sign your mortgage term, it is something that’s increasingly becoming more important to consider over the interest rate itself.
First of all, it’s important to know when you need to pay a penalty on your mortgage. A penalty gets charged when you terminate your mortgage contract with your lender during the course of your mortgage term. So if you take a 5-year term and want to get out of the mortgage contract 2-years into your term, your lender will charge you a penalty. What you can expect to pay as a penalty can vary but generally, the penalty is going to be the greater of either:
- three months’ interest, or
- the interest-rate differential (IRD)
With the IRD, your mortgage lender will want you to pay the equivalent of what they will lose by releasing you from your mortgage term early and lending that money at current market rates. Unfortunately, not all lenders calculate the IRD the same way, and depending on which calculation your lender uses, the differences can sometimes amount to tens of thousands of dollars as recently reported by CBC News where a homeowner was surprised to learn that the penalty for getting out of their five-year mortgage was almost $30,000.
Let’s crunch some of the numbers to help drive this point home. To calculate an IRD penalty, many lenders will take the difference between your contract rate (which is the interest rate your actually paying for your mortgage) and the current rate the lender is charging that most closely matches your remaining term. Using the same example above, if you originally took a 5-year term and are now planning to break your mortgage 2-years later, the lender will use a 3-year rate to calculate the IRD penalty. That calculation can lead to a reasonable payout penalty. Here’s a typical scenario with details on how a Standard IRD Penalty is calculated:
- A client has a $300,000 mortgage balance with an interest rate of 3.5% and still has 3-years remaining on the mortgage term and wishes to pay out the entire mortgage balance. The lender’s current 3-year rate is 3%
- Formula used: 300,000 (mortgage balance) x 36 (months remaining) x 0.50% (3.5% – 3.0%)/12 = $4,500 Penalty
However, a significantly higher penalty will result if the lender takes the difference between the posted rate (also known as the ‘advertised rate’) that most closely matches your remaining term, and then minuses any discount you received when your mortgage contract began. For example, if your lender has a posted rate of 5 per cent and offers you a ‘Best Friend,’ ‘Loyalty,’ or ‘Family’ discount of 2 per cent, that discount is what can come back to get you.
It doesn’t matter what they call the discount they are giving you, but you better believe the lender is documenting it so that should you need to terminate your mortgage early they can still be compensated. This is no different than the expression used when talking about certain casinos “the house always wins.”
Here’s a typical scenario with details on how a Discounted IRD Penalty is calculated:
- A client has a $300,000 mortgage balance with an interest rate of 3.5% however when the 5-year mortgage began the lenders posted rate was 5.1% and the client received a discount of 1.6%. There is still 3-years remaining on the mortgage term and just like our previous example, the client wishes to pay out the entire mortgage balance. The lender’s current 3-year rate is 3.94%.
- Formula used: 300,000 (mortgage balance) x 36 (months remaining) x 2.34% (3.94% – 1.6%)/12 = $21,060 Penalty
- Your IRD penalty has just gone up from $4,500 to $21,060 because the lender uses the discounted rate penalty calculation rather than the standard penalty calculation.
Now if that wasn’t enough, there are also lenders that have a penalty calculation of IRD plus a certain percentage of the total mortgage balance which quite commonly it’s 3 per cent of your total outstanding balance. It’s easy to see how those penalty calculations can really add up and possibly even more important is knowing before you sign for any new mortgage that you understand the math that lender will use should you find yourself needing to break the mortgage early. It’s no wonder why so many Canadians are left scratching their head when it comes to trying to do the math on these calculations.
That’s why professional advice is so important; many people want to solely focus on the interest-rate alone, whereby our team will advise a client about the various interest rate offers and which lenders have the fairest prepayment penalties so they can weigh the pros and cons of each scenario. This is the only way a borrower can make a fully informed decision and factor in the total cost of the mortgage both today and in the future (should a life event dictate needing to get out of a mortgage contract early).
Don’t get stuck on the hook for tens of thousands of dollars in unnecessary penalty costs with your next lender. If you or someone you care about is looking for home financing, all things being equal, like rate and privileges, be sure to take the prepayment penalty into consideration. If your circumstances change and you need to break your mortgage, having a fair prepayment penalty could save you thousands!
Our Benchmark Mortgages team are experts at providing the advice, education, and resources that home buyers and owners need. When it comes to mortgage penalties, it pays to be informed. And we’re here to help!
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