Often when looking at mortgage, many buyers 1st question is “what is your best rate?”.
While rate is certainly a consideration when choosing a mortgage product, knowing the features of the mortgage product should be top priority- because not all mortgage products or lender offerings are equal. In many cases, Canadians often end up paying more in payout penalties than the savings they thought they were getting with their mortgage rate. When a mortgage is broken before it’s term is over, or if a mortgage has been paid down above the privilege limit-there will be a pay out penalty. Depending on where your mortgage resides and what type of mortgage product you have, the differences between the penalties could be thousands of dollars- for the same mortgage amount!
The 5 year fixed mortgage rate is the most common and popular choice with 65% of Canadians signing on to this mortgage type. However 6 out of 10 Canadian home owners move, or change mortgages approximately every 3 years. Which means the majority of home owners are likely paying steeply of their pockets in mortgage penalties because the 5 year fixed mortgage product features hefty penalties. And if that fixed product is a discount product (low interest rate product)- there is potential for an even higher penalty.
Let’s do a simple comparison of payout penalties from a 5 year fixed rate mortgage to a 5 year variable- assuming both products are a full featured mortgage product without an additional penalty terms.
On a variable rate mortgage, the payment penalty is calculated as 3 months worth of interest on the remaining balance at the current rate you are paying. On a fixed rate mortgage penalties are calculated either by an interest rate differential (IRD) or 3 months interest-whichever is higher. IRD penalties are also not created equally as how the IRD is calculated vary differently between the lenders.
A Standard IRD takes the difference between your contract rate, and their current rate that most closely matches the time remaining on your term, then multiplies it by both your mortgage balance and the time remaining on your mortgage. As far as calculations go- the Standard IRD is the most fair. Standard IRD is often used with most monoline lenders and many credit unions and treasury branches.
Discounted-Rate IRD. This type of calculation is used by many of the major banks- and although the name might imply a discount- it will actually make a huge difference to the cost of your penalty and not for the better. The key difference is that the lender takes your contract rate and compares it to the POSTED rate that most closely matches your remaining term minus the original discount you got off their five-year POSTED rate, then multiplies it by both your balance and time remaining. This difference benefits the lender because shorter term fixed rates are not nearly discounted as much as their 5 year fixed. See for example that today, the gap between a 5 year posted rate and contract is around 1.50%, whereas the gap between its two year posted rate and contract rate is 0.10%. Simplified- they will take the original discount the gave you off their 5 year posted rate and apply that same discount to the posted 2 year rate they use to calculate your penalty.
And finally there is the Posted-Rate IRD calculation- which can be even higher penalties than the discounted IRD should the lender that uses this calculation have higher posted rates than their competitors. The penalty is calculated by taking the 5 year posted rate they were offering when you got your mortgage and compares it to their current posted rate the most closely matches the time remaining on your term. then multiplies it by both your balance and time remaining.
Let us show you with this scenario.
Marcy and Louis were first time home buyers 3 years ago but wanted the security of a 5 year fixed mortgage rate. Their lives are changing and have decided that moving to the suburbs would be the best location for them and they need to move now. For simplicity sake lets assume they can not port their mortgage to the new property and must pay the penalty.
They have 2 years left on their mortgage, here are the details:
Mortgage Balance: $335,000
Interest rate: 2.99%
Compare the cost to break this fixed mortgage with the various calculations of IRD from different lending institutions. Remember that in a fixed rate the payout penalty is either 3 months interest or IRD, whichever is higher.
3 month interest rate penalty =$2504.12
Standard IRD penalty calculation= $2579.00
Discounted Rate IRD penalty calculation= $8308.00
Posted Rate IRD penalty calculation= $10,460.00
Wow! So in this scenario Marcy and Louis would be paying an IRD penalty because it is higher than the 3 months interest payment, but if they had their mortgage with a lender using Posted Rate IRD- they would be paying a huge cost to get out of their mortgage- much higher than if they were placed with a lender who uses the Standard IRD.
Variable Rate Penalty Scenario
What if Marcy and Louis had originally decided to go with a variable rate mortgage that was priced at prime minus .50%. With a variable rate you only ever pay the 3 months interest, and often (though not always) the variable rate is less than a fixed. Over the past year, prime increased from when they first got their mortgage so today their interest rate is slightly under a fixed amount at 2.95%. (Not calculated in this scenario is considerable savings on the amount of interest having a variable rate in this time period as when they first got their variable rate 3 years ago, prime was lower and the interest paid floated).
3 month interest prepayment penalty for variable scenario= $2470.62.
Discount product Penalty Scenario
Let’s compare one more scenario- what if Marcy and Louis really focused only on rate when they got their first mortgage. They wanted the absolute lowest rate and so went for a discount product. In many discount products the payout penalty has another factor which is most often:
3% of the mortgage balance, IRD penalty or 3 months interest, whichever is higher.
3% of the mortgage balance= $10,500
The calculations for the 3 months interest rate are above in the first example, along with the various IRD’s, however in this case the addition of the penalty clause of 3% shows that with the discount product- Marcy and Louis are paying a whopping $10,500 in penalties with this type of product.
In summary-
Penalties for paying off mortgages are part of the package, but be sure to understand the varying differences between the rates and products. Sometimes a situation exists where it may make perfect sense to pay the penalty in order to save in interest costs- for example if there are better rates available, you were wanting to port but interest rates are rising and you don’t have much time left on your mortgage or if you are wanting to pay off other accumulated debts. As your mortgage broker(s), we will figure out the numbers for you so that you can see if breaking your current mortgage term is financially positive.
