If you are a sports fan, (like I am) then you know the penalties associated with each sport. In football, if you tackle a player by grabbing their facemask, you know that there is a 15 yard penalty. In hockey, if you slash a player’s arm with your stick, you know that there is a 2 minute penalty for slashing. In soccer, if you trip a player, you know that there is a free kick or penalty shot awarded to the opponent. But when it comes to mortgages, do you know the penalties associated with breaking your mortgage? Are they all the same? Do all referees officiate the same? As you might have guessed, the answer to the last two questions is no.
All mortgage penalties are not the same and each lender does not calculate them the same way. There can be vast differences between penalties and I’ll share them with you here. First, I’ll start by stating what “breaking” the mortgage means. So to incur a penalty a borrower has to break the mortgage; or in other words they are getting out of the mortgage contract. Ways to do that are by: 1) paying off the mortgage in full, 2) refinancing your mortgage or 3) selling your home to move into another place. Any of those actions will result in a mortgage penalty.
So how much are we talking here? Well that depends on the lender you’re with and the type of rate you have; fixed or variable. The variable rate is the easy one to decipher since it is the same across the board. If you have a variable rate mortgage, the penalty is 3 months of interest. Plain and simple. End of story. Whatever balance is remaining on your mortgage you calculate 3 months of interest payment. Every lender does this with the variable rate. Banks, Credit Unions, Monolines, they are all the same. Where they differ is with fixed rate penalties. And oh what a difference it can be.
They all use what is call the Interest Rate Differential (IRD) to calculate the penalty for a fixed rate mortgage. Technically, it is the higher of the IRD or 3 months interest, but rest assured; with Banks and Credit Unions it will undoubtedly be the IRD. Let me describe what the IRD entails. It is the difference in interest that is potentially lost by the lender when you break the mortgage. The majority will use a posted rate, and compare that to the rate available for the remaining term.
Banks and Credit Unions tend to calculate their fixed rate penalties in a similar way. They will use an inflated posted rate when calculating IRD. Let me give you an example. Say you had an interest rate of 2.79%, five year fixed term when you bought last year. You earned a promotion at work but your new positon is in another province, so you need to move. Your mortgage wasn’t portable, so you have to break your mortgage contract and get a new mortgage. With Banks and Credit Unions, even though your rate was 2.79%, the posted rate at the time would be higher, like say 4.84%. Why? For this calculation.
Let’s say an available rate for the remaining term, (4 years) would currently be 2.64%. The difference between the available rate and the posted rate, is used to calculate the interest rate difference. That rate (2.2% in this example) is used in calculating the interest lost for the remainder of the term. Depending on when you break the mortgage, it can be quite a high number. Hearing $30,000 needs to be forked over is not far fetched when it comes to an IRD penalty. Which means there can be a painful bill from the lender waiting for you when you sell your place.
Thankfully Monolines don’t calculate IRD the same way. “What is a Monoline lender,” you might ask? Well a Monoline is a lender that only lends money for mortgages. They don’t hold your money in chequing or savings accounts. They don’t offer TFSA’s or mutual funds. They are strictly in the mortgage lending business, hence the term “mono” line. They are available through mortgage brokers and are a huge part of the industry. They fund billions in mortgages and offer a great alternative to the major banks. One of their major assets, is the way they calculate their IRD.
Instead of using an inflated posted rate, Monolines posted rates are much closer, if not exactly the same, as the best available rate they have. In doing that, their IRD penalties are way lower than the banks. How much lower? Well its safe to say it’s significant. Like a family of 4 trip to Europe significant! Because of the large discrepancy, it’s definitely important to consider carefully which lender you use if you want a fixed rate mortgage. There are obviously other factors to consider, however the possible penalty should be near the top.
So there you have it. Mortgage penalties 101. An eye opener I’m sure for some, who may have thought all mortgages are the same. Some good food for thought for those who are out hunting for a mortgage. Be aware of the penalties involved, or they could cost you.