When shopping for a mortgage very few of us are thinking about the penalty associated with breaking your new mortgage. In fact, I would bet almost none of us think we are going to break our mortgage during the term. Otherwise, why wouldn’t we select a shorter term? The 5 year fixed mortgage is still by far the most popular in Canada. It is the most advertised and we have just recently seen more media hype around big banks lowering their 5 year fixed rates.
All Mortgage Penalties are NOT Created Equal
In Canada most fixed mortgages have a penalty that is the greater of either a 3 month interest penalty or what is called the Interest Rate Differential (IRD) penalty. In this post we are going to focus on the IRD penalty as the 3 month interest penalty is just that, 3 months interest. Pretty simple, right?
The big banks can have slightly differing ways of calculating the IRD penalty but for the purpose of this post I am going to use a very common way. See below a standard way of calculating the IRD penalty. This way of calculating the IRD penalty is used by lenders that only work with mortgage brokers.
The Common Sense Way
For example, John Smith called us up looking for a 5 year fixed mortgage. He was sure this was the perfect product for him as he was definitely not moving within 5 years (yah right). With all the news of smoking deals on 5 year fixed term he was ready to go and we helped him into a 5 year fixed mortgage at 2.69%. Fast forward 2 years and John has had some changes in his life and needs to pay his mortgage out early. Here’s what it looks like:
Mortgage Balance Remaining = $430,000
Contract interest rate = 2.69%
Number of years remaining on his term = 3 years
Lender’s current 3 year mortgage rate = 2.44%
The common sense calculation is:
mortgage amount * (contract rate – current rate for term remaining) * X number of years remaining OR
$430,000 * (.25%) * 3 = $3,225
The Big Bank Way
Firstly, you must understand that with the big banks, the rate you received is always based on a “posted rate”. Even though this rate is well above the market and no one ever pays this rate, it is enormously important to you, the consumer.
If the same John Smith were to have walked into a big bank and finally negotiated down to the same rate we offered him up front, he would have a huge discount off their posted rate. This is a good thing, right? Wrong… The bank’s current posted rate is 4.64% and the rate he negotiated to was 2.69%, that’s a difference of 1.95%.
Remember, John had some unexpected changes in his life 2 years later. As an aside, stats show well over 60% of Canadians experience unexpected changes and need to pay out their mortgage during their term. His situation now looks like this:
Mortgage balance remaining = $430,000
Contract interest rate = 2.69%
Posted interest rate at the time of application = 4.64%
Total discount given at the time of application = 1.95%
Number of years remaining on term = 3
Big bank’s current 3 year mortgage term = 3.65%
Now, the big bank way of calculating the penalty is:
mortgage amount * (contract rate -(3 year posted rate-discount received originally)) * 3 OR
$430,000 * (2.69% – (3.65%-1.95%)) * 3 = $12,771
In John’s case it would have cost him an extra $9,546 going the “Big Bank Way”. As you can see, the interest rate at the big bank vs what SMG arranged were exactly the same. However, using the common sense way of calculating the IRD penalty saved John over $9,500!
I don’t know about you but that $9,500 would go a long way in knocking St. Andrews off my bucket list!