Mortgage rates are still at record lows, yet when looking for a mortgage it is important to look beyond the rates you are being offered and pay attention on how much it will cost to break the mortgage.
Even though you might plan to live in your home for the term of the mortgage, life happens… You might need a larger home as the family is growing, an opportunity to move to another city for a new job, wanting to take equity out of the home, having to sell because of divorce or for health reasons. The penalty to get out of the mortgage early will vary depending on the type of mortgage that you have and the lender that holds your mortgage.
The lender will have two options to determine how much you will pay depending on the type of mortgage that you have. If it’s a variable rate or a fixed rate? If you are in a variable rate, the maximum you would pay most likely is three-month penalty interest. However, if it is a fixed mortgage, you will pay the greater of either the Interest Rate Differential (IRD) or three-month interest.
The IRD is calculated by determining the difference between the mortgage rate in effect and the rate available at the time of the pre-payment multiplied by the term remaining on the mortgage. The interest rate differential is meant to compensate the lender for having the mortgage paid early. Most lenders have different ways of calculating their pre-payment penalties, therefore, it is critical that you find out how they will be calculated upfront before signing your mortgage, even more so if you think you might need to get out early.
A Big Difference
Here is how the IRD can have a huge impact on what your penalty will be. A client that was looking at refinance their mortgage as they wanted to take equity from their home for investment purposes. Their current mortgage was held by one of the big banks. When they signed their original mortgage, the bank had offered them a discounted rate of 2.99 per cent and their mortgage was up for maturity in August 2018.
One would think that the Interest Rate Differential (IRD) penalty might seem to be considerably low because of the effective rate of 2.99 per cent. Except the rate of the original mortgage was discounted from 4.64 per cent (posted rate at that time). Therefore, 4.64 per cent was used when calculating the IRD penalty. To the big surprise, the clients instead of paying $5,157 in penalty, they had to pay over $23,000 in order to break their mortgage with the bank. Since the penalty was substantial the clients decided to wait until their mortgage was up for renewal.
As mentioned above, as mortgage interest rates are still at record lows, the posted rates offered by the big banks have remained much higher. That means that you can receive substantial discounts from the posted rates – yet as seen above that can work against you when calculating the interest rate differential when a big bank determines how much the penalty would be to break the mortgage.
There are monoline lenders (lenders that only work with mortgage experts) and there are many of them use the contract or effective rate when they calculate the IRD penalty on fixed rate mortgages, unlike the banks. Since they use actual contract rate, the penalty would have been much lower for the clients mentioned above.
In Canada, six out of 10 households break their existing five-year fixed term, typically at 38 months. This leaves an average of 22 months’ penalty against the outstanding balance. With a mortgage of $300,000, the penalty would be approximately $14,000 from a bank. The very same mortgage with a monoline lender would be about $2,600. Therefore, by having the mortgage with a monoline lender it was a savings of $11,400.
Whether you are dealing with a mortgage expert or your bank at the time of negotiating your mortgage, you should have them walk you through the penalty calculation so that you fully understand how much it will cost if you need to get out of your mortgage early. If you are not happy with the mortgage that you are presented with, you can walk away before signing and find an option that you are comfortable with.
Focusing on the rate may save you a few dollars on your monthly mortgage payments, yet if you don’t pay attention to the penalty fees, it could end of costing you thousands more if you have to get out of the mortgage early.
A mortgage expert will develop a financial strategy to find you the best mortgage options and will guide you throughout the decision making process, to ensure that you not only consider your current situation yet make sure you look at future scenarios as well.