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17 Jun

Paying a Big Price for the Big Banks

Posted by: Sarah Makhomet

Not all mortgages are created equal, and this is especially true when it comes to the way that some lenders calculate their penalties.  For the majority of fixed rate mortgage contracts, the penalty is described as the greater of 3-months interest, or Interest Rate Differential (IRD).  What is not typically explained is how IRD is calculated.

Before talking about the different way the IRD penalties are calculated, I’ll give a brief explanation of why they are in place.  As a mortgage lender, to ensure profitability, they are relying lending that money for the full length of the term (let’s say it is 5 years).  If rates remained constant and someone breaks their mortgage, the lender receives a small penalty (3-months interest) and should then be able to allocate the same money towards another mortgage at a similar rate.

A few years ago however, five year fixed mortgage rates fell from above 5% to below 4%, and in the past year to below 3%.  To compensate the lender, should the borrower break the rate they had at 5.25%, and get a new rate at 3.75%, an IRD penalty would be applied (5.25%-3.75%=1.5%).  At the time they broke this contract, if they had 3 years remaining, the penalty would be 4.5% (1.5% x 3 years).

As I indicated earlier, when it comes to penalties, not all mortgage are created equal.  Below is a list of current bank post rates, discount rates & Canada bond yields.  When calculating the penalty, a few lenders will use a discount-to-discount calculation (this is primarily with non-bank “A” lenders), some will use a posted-to-posted, or a posted-to-discount (these two are primarily used by the banks (RBC, BMO, etc.) & some will use discount-to-bond yield, or posted-to-bond yield (these last two are primarily with lenders offers ultra discounted rates

1-year                                   3.14%                    2.79%                    1.13%

2-year                                   3.14%                    2.69%                    1.15%

3-year                                   3.65%                    2.65%                    1.43%

4-year                                   4.54%                    2.99%                    1.47%

5-year                                   5.14%                    3.09%                    1.53%

For an example of the difference in penalties, let’s assume the following:

– Mortgage size = \$300

– Term = 5-years

– Mortgage rate = 3.09%

– Client sells their house and breaks the mortgage at the end of year 3 (2 years remaining on the mortgage

– At the time of the penalty, rates are same & the mortgage balance is \$250K

– Each of the penalties is calculated as follows:

= Initial rate – rate of remaining term x years remaining x mortgage balance outstanding

For discount-to-discount = 3.09% – 2.69% x 2 x \$250,000 = \$2,000

For posted-to-posted = 5.14% – 3.14% x 2 x \$250,000 = \$10,000

For posted-to-discount = 5.14% – 2.69% x 2 x \$250,000 = \$12,250

For Discount-to-Bond = 3.09% – 1.15% x 2 x \$250,000 = \$9,700

For Posted-to-Bond = 5.14% – 1.15% x 2 x \$250,000 = \$19,950

As you can see, there is quite a difference in how the penalties are calculated.  I’ve spoken with many clients who fight to save 0.1% on their mortgage rate.  On a \$250K mortgage, this 0.1% would save them less than \$250 per year.  In trying to save a few hundred dollars, I’ve seen many people cost themselves thousands, or tens-of-thousands of dollars in penalties.

Before you sign your next mortgage contract, ask your broker or bank representative to explain how the penalty is calculated.  Most of the descriptions of the penalties are very complex and difficult to understand.  To simplify this, look for the words posted or bond rates.  If they are included in the penalty description, the mortgage you are looking at may be more expensive than you think.