## Not All Mortgage Penalties Are Equal

This is a story about Joe and Sue. Two different people with similar mortgages, but very different prepayment penalties.

Joe and Sue each buy a house at the exact same time for the exact same price and get a mortgage for the exact same amount. The only difference is Joe uses a Big Bank, and Sue uses a monoline lender for their mortgages. Let’s assume they both received a rate of 2.99% for a 5 year fixed term.

Three years into their mortgages, Joe and Sue are both going to be paying off their respective mortgages which are both at \$250,000 at the time of the payoff. Now to keep the comparison fair, we will pretend that interest rates have not changed at all for any of the terms, whether it is the posted rates or the discounted rates. The rates are made up for example purpose only.

Now because they have ended their 5 year contract early, they will have to pay a penalty. Both agreed at the time they took out their mortgage they would pay the greater of 3 months interest or the Interest Rate Differential (IRD). The IRD is in place so that the lender will be reimbursed for any income they would lose because you broke the contract early. In theory, it should only apply when rates have gone down from the rate you agreed to pay. In this example, they each agreed to pay 2.99% for 5 years, so if rates had dropped to 1.99%, the lenders would be entitled to the 1% difference for the remaining two years. Which is fair. If you invested \$1000 and were told at maturity your investment would be worth \$1200, you would not want to get \$50 and be told, “sorry, someone else changed their mind.” You, like everyone else, would want the full \$200 you were promised. Same idea. Only the Banks are using the IRD to punish you for leaving or to force you to stay with them. Which is not fair, nor the idea behind an IRD.

In our example, Joe and Sue each have to pay a penalty. But how much they have to pay is a shocking difference!

Sue’s Monoline Penalty: \$1,868

Joe’s Big Bank Penalty: \$8,750

That’s a difference of \$6,882 !!!

So why such a huge difference? In the simplest explanation, it’s the “discount” given by the big banks.

Let me explain. With a Monoline lender, like Sue used, that mortgage brokers usually use, they offer their best rates upfront. They generally only have one rate for each term length. Whereas the banks have two rates for each term. The posted rate, and the discounted, or special offer rate. Almost everyone actually pays the discounted rate, but the banks use the posted rates when calculating the Interest Rate Differential. That is how they come up with huge IRD penalties.

The math behind it can be a bit confusing when you read it, so pretend you’re back in high school math class but pay attention this time.

The banks take the rate you are paying (2.99% in our example) subtract the difference between what is the current posted rate for a similar term for the time remaining (2 years at 3.04%) less the discount given. The posted rate in our example is 4.79% minus the real rate of 2.99% which is a discount of 1.80% That is what is going to cause the variance between the two scenarios. They take the similar posted term rate then minus the discount (3.04% – 1.80%). Then they multiple that number by the balance owing and the time remaining.

Big Bank IRD calculation

2.99% – (3.04% – 1.80%) x \$250,000 x 2 years = \$8,750

Compared to a true IRD calculation

(2.99% rate – 2.79% comparable rate for term remaining) x \$250,000 x 2 years = \$1,000 which is less than the 3 months interest, \$1,868, which is what Sue would be paying. The Interest Rate Differential should not have come into play.

The numbers being used are for example purpose only,

Posted Rate for 5 year term    4.79%
Rate Clients are paying for 5 year term    2.99%
Posted Rate for 2 year term    3.04%
Discounted Rate for a 2 year term    2.79%

To make up for such a monstrous penalty from his bank, Joe would have needed a rate of 1/2 of a percent (0.5% or 0.005) which is 2.49% lower than the best rate at the time from the banks. There is more to consider with a mortgage than just rates. Know your other risks.

At the time of writing penalties according to the Big 5 Banks online calculators and their listed posted rates: BMO \$8750, Scotia \$8250, RBC \$9057.85, CIBC \$10,677.65, TD Canada Trust online calculator not working but it would be \$8750. The Banks penalties differ somewhat mainly because of differences in the banks posted rates.

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