When you are selling off your house, you need to consider all the costs associated with the transaction. A key question is, “What happens to my mortgage?”
Since all mortgages are not created equal, it’s important to make sure you read the fine print especially when it comes to the pre-payment penalties. When people are looking for a mortgage, they normally look for the best interest rate. What is important in a mortgage is not just the rate but the overall terms and pre-payment clause.
It is common for lenders to use ambiguous language that makes it difficult for borrowers to clearly understand how expensive it can be to pre-pay (pay out) your mortgage before the end of the term. As a result, borrowers trying to break their mortgage are constantly shocked and upset by the high penalty cost.
All closed mortgages have pre-payment clauses that say that if you pay off your mortgage before the end of the term, you would have to pay a penalty. The penalties for fixed rates are the most costly mortgages to pre-pay.
There is no magic formula to determine the IRD (interest rate differential) penalty as each bank has its own calculation formula and there is not a standard guidelines that lenders have to follow. However, in 2012 the Department of Finance asked the banks to agree to a “voluntary” code of conduct that requires them to post in plain English explanations of prepayment charge calculations and provide web site calculators so borrowers can run their own penalty estimates.
The penalty for fixed rate mortgages is the greater of:
- three months’ interest at the interest rate of the loan calculated on the mortgage amount being prepaid; or
- the IRD (interest rate differential), calculated by determining the difference between the mortgage rate that you have and the rate available at the time of the pre-payment, multiplied by the term remaining on the mortgage.
The average mortgage term is five years, but you never know when your financial strategy and needs are going to change, reasons why you should understand all the pros and cons of the mortgage term, what they mean and above all what the potential monetary implications are.
Before settling on a lender, if you are looking at a five-year fixed term, ask your mortgage broker to estimate the lender’s penalty as if you planned to break the mortgage after 3.5 years (the average time most borrowers break their mortgage), assuming that rates stay the same. It pays to have an idea if you were to pay off your mortgage earlier in advance and avoid surprises later.
Next time: Key FAQs to ask your lender about pre-payment penalties
