UNDERSTANDING MORTGAGE PENALTIES
UNDERSTANDING MORTGAGE PENALTIES
Mortgage Penalties. They've become a hot topic recently. We know and accept that they are there, and we know that if we are to break our term - one will be charged.
What many consumers don't know, is how those penalties are calculated - and how those calculations differ, according to your product, lender, and term.
While most purchasers, and those refinancing - do so with the intention of keeping that mortgage for the full term, that is often not the case. Statistically, the average mortgage term is only 38 months - which means that many will wind up paying penalties. All the more reason to ensure that you understand them, and what it means for you. A little knowledge here can save you some serious money.
Borrowers, most often choose 5 year terms.
A 5 year variable rate mortgage typically comes with a 3 month interest penalty, so if this is your mortgage - you likely don't need to be too concerned. A 5 year fixed rate penalty, however is very different. These penalties are almost always calculated based on "the greater of 3 months interest or an interest rate differential (IRD)". The manner in which these IRD's are calculated differ from lender to lender, and the calculations used by some of the most prominent lenders can result in a penalty 3 or 4 times greater than what you might be charged with other lenders.
The standard IRD calculation, offered by many lenders, takes the difference between your rate (say 2.99%), and their current rate that most closely matches your remaining term (2.59%). This .30% difference, is what they use to calculate the IRD.
The lender simply multiplies your remaining balance ($300,000), by the number of months remaining in your term (24) divided by 12 (to arrive at number of years). The penalty in this case, is $1800
The majority of the monoline lenders use this calculation, while many other well known lenders (the big banks and credit unions) use a different calculation, using the discounted rate method.
The discounted rate method, takes your current contract rate and compares it to the bank posted rate that most closely matches your remaining term, MINUS the original discount that you got off your posted rate.
If you have 2 years remaining in your term, they take the discount they gave your off of your original 5 year term, and deduct it from the posted rate on the 2 year term. The reason this is so lucrative for the bank is because they don't discount shorter terms as heavily as the longer terms. And as the 5 year term is the most popular, this one has the heaviest discount. Basically, the better your rate -the more your penalty will be.
Your rate is 2.99%. At the time that you got the mortgage, the posted rate was 4.94% which makes your discount 1.95%. You currently have 2 years left in your term. The 2 year posted rate is 3.55%, so the rate they are using to calculate the penalty is 1.6%. The penalty is $10,140
This is a difference of $8340! On the same mortgage, with the same rate.
Obviously, these mortgage penalties generate huge profits for the lenders who use them and when borrowers negotiate directly with their bank, they're not going to point this out.
Things are changing. The Federal Finance Minister is now calling for better disclosure of how penalties are calculated, and the lenders have started spelling it out in more detail.
The majority of Canadians don't know that there are differences. And in many cases, for many borrowers, who really are certain that they are going to be in their home and mortgage for the long term, it won't affect you. But..... if all else remains the same, and you are getting the same rate, and product from a monoline lender with a much more attractive penalty calculation, why not give yourself the flexibility to save yourself some money, should the opportunity arise?
