What You Need To Know About Mortgage Penalties

What You Need To Know About Mortgage Penalties

A penalty to break a fixed rate mortgage is typically "the greater of 3 months interest or the Interest Rate Diffential (IRD)". Large penalties are typically the result of "IRD".

There are actually 3 basic variations to the calculation of an IRD penalty used by various institutions:
(1) Posted rate IRD penalty;
(2) Bond rate IRD penalty;
(3) Discounted rate IRD penalty;
As a mortgage broker I will not often recommend a client choose to go with a fixed rate mortgage at one of the ‘big banks’ (there would need to be a very unique reason) simply due to the way they calculate penalties (posted rate IRD described above).
The fact is that none of us can predict our future and the potential for needing to exit the mortgage early (illness, job loss/relocation, divorce, etc).
What most consumers don’t know is that there are a wide variety of other VERY reputable Canadian mortgage lenders available who DO NOT calculate penalties the same way the BIG six banks do.
These lenders don’t work off of ‘fake posted rates’; they only offer ‘discounted rates’ so an IRD penalty calculation is very straight-forward: “your actual discounted rate less the actual discounted rate of a term equal to that remaining x Mortgage amount being paid out = interest rate differential penalty” - most people can understand that their original 5-yr contract represented a promise to the financial institution (in actual fact a promise to someone’s mutual fund/investment income somewhere) to pay that amount of interest over the term. It is not unreasonable to be responsible to compensate for the shortfall a financial institution (read an investor) will not be receiving due to exiting the mortgage early. So a fair penalty to exit a contracted obligation early is deemed acceptable. An over-inflated penalty that offsets the loss on original contract AND generously pads the banks quarterly profits is not.
Challenges may still arise in large $$ penalties being charged due to the fact that some people have VERY large $$ mortgage balances; and sometimes (ie now) the monetary markets are not operating in a normal way due to events like covid and this results in an upside down effect of shorter term rates vs longer term rates and the ‘differential’ becomes magnified. So this is when mortgage penalty stories tend to hit the news more regularly.
My advice always:
(1) Make sure to choose your lender on more than just the lowest mortgage interest rate (how the banks have trained consumers to shop for a mortgage) - because the lower rate does not always translate into the cheapest cost mortgage!!
(2) Always understand how the IRD mortgage penalty calculation is actually calculated and unless there is a very good reason you need to be with a specific lender for another reason, avoid lenders using methods 1 or 2, if possible.
(3) Seriously evaluate whether a shorter than 5-yr term or a variable rate mortgage (typically limited to a 3 mos interest penalty) might make more sense.
 
(4)  NEVER sell your home without FIRST investigating whether there will be any penalties that apply to your situation. Speak to your mortgage broker or lender first to ensure you have an accurate understanding of the consequences a sale might involve.  Don't get caught by surprise when sitting in your lawyer's office on closing day!!
 
While nobody EVER thinks they will want to exit their mortgage when they are in the process of applying for one, it is SUPER important that the cost of potential future mortgage penalties be given serious consideration.   Instead of restricting your future decision making with a bad choice today for the sake of a few basis points on interest rate - why not set your mortgage up for FUTURE flexibility right from the start by first choosing the right lender?   The cost of FUTURE FLEXIBILITY can be PRICELESS!!  smiley

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