Okay so you have a mortgage. Let’s face it, it’s a contract with terms, conditions, rights and obligations for both you and the lender. However, now for whatever reason you need or want to break the contract before the end of the term. Many mortgage lenders will allow this provided they are compensated. You have a rate of x.xx%, the best they can lend to someone else right now is 1% less so they want the difference, known as Interest Rate Differential or IRD. Seems fair right? Right. However, as is often the case, the devil is in the details. It is the method of calculating IRD that borrowers should be aware of as not all mortgages are created equal.
Let’s look at a couple of methods commonly used with what we Mortgage Brokers call “A” business. A or AAA business is where everything on the file makes sense, good credit, documented income and a normal residential type property. This is the vast majority of mortgage business on the books in Canada.
Method A – Posted Rate Method
This method uses lender posted rates to arrive at the formula to calculate the penalty. Posted rates are generally used by major Banks and some Credit Unions. These are the mortgage rates you will see on their websites and you will recognize them because the rates will not appear reasonable. They subtract a discount from these rates to arrive at the actual lending or contract rate. Nobody pays posted rates. Let’s say the posted rate for a 5 year term is 4.90% but you are savvy, able to negotiate a discount of 2% and come away with an actual mortgage rate of 2.90%.
Everything is rolling along great for 2 years when, for whatever reason, you need to exit the contract. What will my penalty be you ask, hopefully of the lender, while silently begging for mercy? The answer; the greater of 3 months interest or IRD. Okay 3 months interest sounds good but IRD sounds scary! It can be scary as it is subject to a formula over which you have no control and can be easily manipulated. You have 3 years left on your contract, the lender says their “Posted Rate” for 3 year terms is 3.40%. You think great! My rate is 2.90% your rate is higher at 3.40%, no difference just 3 months interest and I’m outta here! Wait a minute…remember that 2% discount you negotiated? That’s right, it gets subtracted from the posted rate to arrive at the rate that will be used to calculate your penalty. So 3.40% – 2% becomes 1.40%. Who lends at 1.40%? No one. However, your contract rate is 2.90% – 1.40% equals a IRD difference of 1.50%, times 3 years left on the contract equals a penalty of 4.50% of your mortgage balance. Gulp! On a mortgage of $300,000 that is a $13,500 penalty.
The main underlying problem with this method is the fact the posted rates and /or the discounts, can be easily manipulated depending on the interest rate curve, to favour the lender. What happens in today’s interest rate environment with a gently sloping curve is that posted rates decrease from long term to short term however, so do the discounts. For example, a 2% discount on a 5 year fixed term is close to actual nowadays however, you would never get a 2% discount from posted on a 3 year term. Less than 1% would be more realistic.
Let’s look at another common and more favourable method.
Method B – Published Rate Method
This method uses lender published rates which are close to actual lending rates but do not include unpublished rates, which may only be available to Mortgage Brokers or Quick Close specials, among others. Generally these rates are used by Wholesale lenders, many of whom acquire all or most of their business from Mortgage Brokers. You will see these rates on the lender websites and will recognize them because the rates will appear reasonable. Let’s look at an example using the info above but let’s assume at outset you chose a Method B lender as opposed to a Method A lender and compare. Let’s assume your rate is 2.90%, which was the published rate at the time or a special your Mortgage Broker obtained for you. You want to exit the mortgage at the same 2 year point in time. What will my penalty be you ask, hopefully of the lender, while silently begging for mercy? The answer; the greater of 3 months interest or IRD. You have 3 years left on your contract, the lender says their “Published Rate” for 3 year terms is 2.60%. You think great! My rate is 2.90% your rate is 2.60%, not much difference…and you would be right! No discounts involved, just a straight up comparison. Your contract rate is 2.90% – 2.60% equals a difference of 0.30% times 3 years left on the contract equals a penalty of 0.90% of your mortgage balance. On a mortgage of $300,000 that is a $2,700 penalty. Much easier to swallow than $13,500!
Think these numbers sound too far apart to be real? Not at all. In the above examples I have used rates fairly close to actual. This means that in the time frame covered, above rates are and have been essentially flat or slightly declining. So even though rates are/have been roughly the same for the lenders at the time origination vs time of exit, which means there cannot be much harm accrued to the lender, one method produces a very punitive penalty. Doesn’t seem fair does it? The Government recently stipulated that lenders must better disclose their methods, be more transparent and use plain language. However, the Government did not mandate which methods are to be used. So it is buyer beware! As always, get independent professional advice. We here at Dominion Lending Centres can guide you through the maze.
Now the caveat: having said all that, we do in fact support the major banks and credit unions and send billions of dollars of mortgages their way each year. Why? Well, they have by far the widest product selection available in the marketplace. Mortgage products and structures that you simply cannot get anywhere else. This is important because the first question I am asked by a borrower is “can I get approved?” All else is secondary. When it comes to penalties, forewarned is forearmed! Best to know going in. A Mortgage Broker can advise what best options exist and will know which lenders use which methods or variations of them.
Moral of the Story: As always, get independent professional advice on which lender and options are right for you. Your local independent DLC Mortgage Broker can help.
Good to know tidbits:
A closed mortgage also works in your favour, after all, as long as you are not in default, the lender can’t call you up and say, listen we found someone else who is willing to pay a higher rate than you have and we want out, we would like you to repay us ASAP. Gasp!
Variable rate mortgages generally charge a penalty of 3 months interest, no IRD. However, this is not true of all. Again, get independent professional advice.
By law, if you have a mortgage term longer than 5 years and you exit after 5 years have elapsed, the maximum penalty is 3 months interest.
Thanks to my DLC colleague Len Anderson for this article.