Wednesday, 15 July 2015

Early Payout Penalties: 101

Are you concerned about being locked into your mortgage? You might be, and here's why.

Easily the most misleading and often misunderstood part of mortgages deals with "Early Payout Penalties" and "Pre-Payment Charges". Although the idea of charging a fee for breaking your mortgage term is quite simple on it's own, the difficulty comes when lenders are left to decide for themselves how this penalty is calculated.

Currently in Canada, there are only a limited set of standards and that the lenders must abide by when calculating these penalties. The law holds that penalties must be deemed "reasonable", and the most common calculations are as follows:

  • For Variable Rate Mortgages - Three months interest, calculated at your current rate.
  • For Fixed Rate Mortgages - The greater of: 
    • 3 months interest penalty 
    • OR the Interest Rate Differential penalty
Unfortunately, many lenders take liberties in the formulas used to calculate these penalties, and as a result some are much more costly than others.(see below)

3 Months Interest Penalty

Let's assume you currently have a mortgage balance of $200,000 at 3.5% interest with 2 years remaining and you want to pay your mortgage off in full. This could be because you have sold your home, have the cash and would like to pay it in full, or because you would like to refinance with another lender. Any of these activities constitute paying off your mortgage and therefore invoke a penalty.

The calculation for the 3 Month Interest Penalty is:

Current Mortgage Balance($200,000) * Your Monthly Rate(3.5% / 12) * # of Months(3) = $1500.00

Interest Rate Differential

Using the same scenario as above, the interest rate differential attempts to calculate the amount of interest your lender will lose when your mortgage is no longer with them. Depending on the circumstances(are rates higher/lower than your contract rate?), this penalty could be more or less than 3 Months Interest. Assume in this case that the lenders current rate for a term closest to your remaining term(2 years) is now 2.69%.

The calculation for the Interest Rate Differential Penalty is:

Current Mortgage Balance($200,000) * Number of months remaining in term(24) * Difference in your rate vs. Similar Term Current Rate(3.5% - 2.69% / 12) = $3240.00

As you can see, since interest rates have fallen, the IRD penalty is significantly more than the 3 Months Interest. In this case if you have a fixed mortgage rate, you will pay the IRD because it is the GREATER of the two penalty options.

But Wait, There's More!

In addition to the "Standard" IRD and 3 Months Interest penalties described above, many lenders ave crafted their own versions which make for higher penalties if/when you break your mortgage term. Here are a few of the possibilities:
  1. Greater of three months interest penalty OR  the interest rate differential.
  2. The mortgage can not be paid out unless there is an arm's length sale - then the penalty is 3% of the outstanding mortgage balance.
  3. The mortgage can not be paid out unless there is an arm's length sale - then the penalty is the greater of three months interest OR  3% of the outstanding balance
  4. Same as above, but not more than three months interest in years 4 and 5 of a five year term
  5. For non-arm's length sales - it is the greater of three months interest OR  interest rate differential to the bond rate for the remaining term
  6. For arm's length sales - it is the greater of three months interest OR  IRD to the current posted mortgage rate for remaining term.
  7. And finally, some lenders use the greater of three months interest OR the IRD to current posted rates, including your original rate discount. 

Ouch!

Of all the possible calculations above, by far the most significant is the 3% of your outstanding balance(worse still if there must be a bona fide sale), or the IRD to posted rate with your discount. By using posted rates and discount percentages, the banks are able to enforce larger penalties, while still technically following the current laws. With either one of these clauses in place, you can be sure that it will cost thousands to break your term or pay off your mortgage early.

How To Protect Yourself

With all the different mortgage companies and products available, it's important to have someone knowledgeable and trustworthy go over the terms of your mortgage agreement with you. You should know well in advance exactly which penalties you might be subject to, and how they are calculated. A licensed mortgage broker will have the necessary skills and knowledge to help you understand these risks and make a decision that is most comfortable for you.

In most cases, lenders who are offering deeply discounted rates will apply the most harsh penalties. For some more info on this read: Super Low Rate = Super Low Features

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