When shopping for a mortgage, the majority of consumers ask one question, what is your best rate? True, some ask questions beyond rate, as they should, and today I’m going to help the majority look beyond rate. What if you obtained the lowest possible 5 year fixed rate on day one but two years later the penalty is ten’s of thousands of dollars? Did you really get a great deal? Let’s investigate…
Let’s take a mortgage balance of $375,500 and a 5 year fixed interest rate of 3.49%, which you have had for the past two years. And for whatever reason you have decided to break the term of your contract, maybe it’s to take advantage of today’s lower interest rates, debt consolidation, selling the existing home, etc…
A standard IRD (Interest Rate Differential) penalty would look like this:
Mortgage balance = $375,500
Your contract 5 year fixed interest rate = 3.49%
Number of years remaining on your term = 3 years
Current 3 year mortgage rate (term closest to the term remaining)= 2.89%
Standard IRD Penalty = A x C x (B-D)
$375,500 x 3 x (3.49% – 2.89%) = $6,759
Standard IRD Penalty is $6,759
Standard IRD penalties are typically offered by non-bank lenders available through the mortgage broker channel and are significantly different from that of a big bank IRD penalty calculation. Let’s look at a ‘Big Bank’ IRD penalty (I won’t mention which bank this is, but they are all similar).
Bank IRD penalty calculation:
First, we must determine your ‘discount’. To do this we must look back in time to when you first took out your mortgage 2 years ago…what was the posted rate? If you can’t remember, it should be posted on your original mortgage document. If you still can’t find it, I would suggest you consult your Bank representative. On the same mortgage document should be a break down of the mortgage penalty calculation, if not, you can find the break down below.
Part 1: Find the discount
The Bank 5 year fixed posted interest rate = 5.59% (This is the posted rate at time you took your mortgage out…your bank can let you know what it is)
Your contract 5 year fixed interest rate = 3.49% (this is the rate you were given)
5.59% – 3.49% = 2.1%
Your discount, the difference between the posted rate and your contract rate, is 2.1%.
Part 2: Choose the term closest to the term remaining
To do this, visit your bank website to select the term and corresponding posted fixed rate.
Part 3: The calculation
Mortgage balance = $375,500
Your contract 5 year fixed interest rate = 3.49%
Number of years remaining on your term = 3 years
Current 3 year mortgage rate (term closest to the term remaining)= 2.89%
Your discount (as determined above) = 2.1%
Current 3 year posted rate = 3.44%
Bank IRD penalty = A x C x (B-(F-E))
$375,500 x 3 x (3.49% – (3.44% – 2.1%))
$375,500 x 3 x 2.15% = $24,219.75
Your bank IRD penalty is = $24,219.75
What’s the average annual rate of interest, non-bank vs. big bank?
Bank
Average annual rate of interest: $375,500 x 3.49% = $13,104.95
IRD Penalty per year: $24,219.75 / 2 = $12,109.88
($13,104.95 + $12,109.88) / $375,500 = 6.72%
Average annual rate of interest: 6.72%
Non-bank
Average annual rate of interest: $375,500 x 3.49% = $13,104.95
IRD Penalty per year: $6,759 / 2 = $3,379.50
(13,104.95 + 3,379.50) / $375,500 = 4.39%
In conclusion, when looking at the illustration, it is clear that in the bank example, the lower the interest rate, the higher the discount, which means the larger the penalty. It is critical to do your homework to avoid situations like this where your penalty can double, triple or worse. It is known in the industry that some where between 60% – 70% of mortgage holders do not carry their mortgage to maturity. Make sure you are asking the right questions of you mortgage provider, bank or broker. By virtue of the employee/employer relationship, it is difficult to receive unbiased advice from a big bank and my suggestion would be to speak with a mortgage broker, even if it’s for a second opinion. Oh, and if dealing with a bank, ask the representative how they calculate their penalty.
Lastly, we are committed to helping Canadians save money and become mortgage free faster. To help you with asking the right questions, we have created a ‘Shopping Around’ questionnaire with 5 basic, yet very important questions. If you are interested in learning more, we would encourage you to call us at 403.250.2100.
