The 2 Types of Mortgage Penalty Calculations
We have all heard the horror stories about huge mortgage penalties. Like the time your friend wanted to refinance her home so that she could open a small business only to find out that it was going to cost her a $13,000 penalty to break her mortgage. This should not come as a surprise. It would have been in the initial paperwork from the mortgage lender and seen again at the lawyer’s office. A mortgage is a contract and when it is broken there is a penalty assessed and charged. You will have agreed to this. The institution that lent the money did so with the expectation that they would see a return on that investment so when the contract is broken there is a penalty to protect their interests. If you think about it, there is even a penalty to break a cell phone contract so the provider can recoup the costs they incurred so it stands to follow that of course there would be a penalty on a mortgage.
The terms of the penalty are clearly outlined in the mortgage approval which you will sign. The onus is on you to ask questions and to make sure you are comfortable with the terms of the mortgage offer. With so many mortgage lenders in Canada, you can very easily seek out other options if needed.
There are 2 ways the mortgage penalty can be calculated.
1. 3 months interest – This is a very simple one to figure out. You take the interest portion of the mortgage payment and multiply it by 3.
For instance: Mortgage balance of $300,000 at 2.79% = $693.48/month interest X 3 months or $2080.44 penalty.
2. The IRD or Interest Rate Differential – This is where things get trickier. The IRD is based on:
- The amount you are pre-paying; and,
- An interest rate that equals the difference between your original mortgage interest rate and the interest rate that the lender can charge today when re-lending the funds for the remaining term of the mortgage.
In Canada there is no one size fits all in how the IRD is calculated and it can vary greatly from lender to lender. There can be a very big difference depending on the comparison rate that is used. I have seen this vary from $2850 to $12,345 when all else was equal but the lender.
Things to note:
- You will be assessed the GREATER of the 2 penalties.
- You should always call your lender directly to get the penalty amount and do not rely on online calculators
- You can avoid the penalty by porting the current mortgage if you are moving or waiting until the end of the term
- A variable rate mortgage is usually accompanied by only the 3 month interest penalty
Given that 6/10 mortgages in Canada are broken around the 36 month mark, wouldn’t it be better to find out before you sign how your mortgage lender calculates their penalty just in case?