When looking for a mortgage, what’s the most important thing? Most Canadians will say they get the lowest mortgage rate. While getting a low mortgage rate certainly matters, it’s important to recognize that there are other things to consider as well.
There is a difference between getting the lowest mortgage rate and the lowest cost of borrowing. Getting the lowest mortgage rate is just that, the lowest rate mortgage. Whereas getting the lowest cost of borrowing takes into account other things like prepayments and penalties. In this article this month, we are going to talk about sanctions.
When you take out a mortgage, the last thing you think about is probably breaking it. But sometimes life does come and you have to end it sooner than you expect. This could be for a number of reasons: moving for a job promotion, job loss, divorce and the list goes on. If you didn’t take the time to educate yourself on mortgage penalties when you first bought your mortgage, you could find yourself blinded by a hefty penalty.
In this article, we’ll see how mortgage penalties are calculated for both variable and fixed rate mortgages. After reading this article, you will have a much better understanding of how mortgage penalties work and what to look for.
Variable rate mortgage penalties
If you’ve taken out a variable (or adjustable) rate mortgage, the penalty is pretty straightforward. You will pay three months of interest for early termination of your mortgage. This is the calculation of the most favorable mortgage penalty (in addition to paying no penalty of course). Whether you belong to one of the big banks or a single line lender, your penalty will be three months interest.
For example, let’s say your mortgage rate is 2.49% and you have a mortgage balance of $ 500,000. In this case, your mortgage penalty would be:
2.49% × $ 500,000 × (3 months / 12 months) = $ 3,113
Quite simply wouldn’t you say? Whether you break your mortgage one month over four years, three months later your mortgage penalty is the same.
Fixed rate mortgage penalties
If you buy a fixed rate mortgage like most Canadians, calculating the mortgage penalty is a bit more complicated. You will pay the greater of three months of interest or something called an “interest rate differential” or IRD for short. If you’ve read stories in the media about Canadians paying huge mortgage penalties, the IRD is probably the reason.
Using the same numbers as above, even though your mortgage rate is only 2.49%, if you are with one of the big banks with the posted rate of 4.79%, you are that time it can really inflate your penalty.
Suppose you have three years left on your mortgage and your lender’s three-year fixed mortgage rate is 2.25%. If we use the IRD, your mortgage penalty would be:
$ 500,000 × 36 months × 2.54% (difference between 4.79% and 2.25%) / 12 months = $ 38,100
Since the IRD penalty calculation is greater than the three-month interest calculation, you will have to pay a penalty of almost $ 40,000 to break your mortgage early. I don’t know about you, but it’s a lot of dough!
The example we have shown here uses a version of IRD known as the Standard IRD which is based on the current posted rate for a similar comparable term. There are many other versions of IRD and penalty calculations. Some lenders calculate their penalties on the posted rate when you got your mortgage, some deduct the discount you originally received from the posted rate, some ask you to repay the cash back you originally received, some calculate the penalties in a totally different way, like 12 months interest or 3% of the balance. The only real way to find your penalty is to ask your lender.
The bottom line
It’s important to ask about mortgage penalties up front so you don’t have to pay a penalty like this later.
If you want a fixed rate mortgage, but don’t want to have to pay a huge penalty out of pocket, you can consider taking out a fixed rate mortgage with a monoline lender instead of the big banks. Monoline lenders don’t have high posted rates like the big banks, so your mortgage penalty will likely be much lower if your mortgage breaks.
If you have any questions regarding your mortgage, please contact us and we will be happy to guide you in the best possible scenario according to your needs.
