An Introduction to Mortgage Penalties
Mortgage penalties rarely hit the news, though an Edmonton couple told their mortgage penalty would be $17,000 recently did. Nor are they the only case where mortgage penalties hit five figures.
What many don’t understand is how mortgage penalties are calculated. Even fewer understand how to dramatically reduce or eliminate the penalty.
What Is a Mortgage Penalty?
A mortgage penalty is a financial penalty for breaking the mortgage contract early. The penalty is levied to compensate the lender for the expected interest and profit they’d have earned if you’d stayed with the mortgage. Some homeowners find that mortgage penalties apply if they try to pay extra on the mortgage beyond the limited amount the lender lets them prepay, since it shortens the loan term so much that a penalty is applied in this case as well.
How Much Is My Mortgage Penalty?
Not all Calgary mortgage lenders use the same methodology to determine a mortgage penalty, but there are rules that we can use to generate an estimate.
The mortgage penalty is the higher of two different calculations. One penalty is simply three months interest on the loan. The other is determined based on the interest rate differential. The interest rate differential equals the difference between the interest rate of your current mortgage and the interest rate the lender could earn on the money at today’s rates for the remainder of the loan. Not all lenders calculate this the same way. If you’re 3.5 years into a loan, some lenders will use three years and others will use four years as the basis of the calculation. Even more punitive is that some banks us their posted rates which arbitrarily makes the penalty several times larger, where other lenders will use their discounted rates, keeping the penalty in line with what is fair. Josh Tagg as a trusted Calgary mortgage broker is happy to review your situation individually to make sure you are in the right product.
The interest rate differential or IRD is capped by law at a maximum term of five years. So for longer terms, such as a 10-year fixed, and you’re six years into your term, the maximum penalty you can be hit with is three months’ interest on the loan. The interest fees are the minimum you’d expect to pay as a mortgage penalty. The lender can pile on administration charges and discharge fees, too.
If you have a variable rate mortgage, you may not be hit with a mortgage penalty at all if you’re refinancing to a fixed rate mortgage with the same lender.
How to Avoid Mortgage Penalties
One option is sticking out your current payments until your mortgage comes up for renewal, a common solution given that most mortgages are set to renew in year five. Barring this, managing to make a couple months of payments as you approach the maturity date will reduce the IRD based mortgage penalty.
If you’re planning on buying your first home, talk to a Calgary mortgage broker. Too many home buyers focus on getting the lowest interest rate instead of a loan without a prepayment penalty or low fees if they need to break the mortgage and move. However, if you’re in a loan with high mortgage penalties, there’s no point breaking the contract to shift to one with lower penalties or even lower rates.
Your Options for Reducing Mortgage Penalties
If interest rates are going up, the IRD based on the interest rate differential is going to go down. The Bank of Canada raised interest rates slowly over 2017. It said it wasn’t planning on increasing interest rates at the January, 2018 meeting, but if Canada’s economy continues to expand, they may increase rates yet again. This means that if you’re planning on breaking your mortgage, waiting until the interest rates go up will significantly reduce your mortgage penalty.
Conversely, if they lower interest rates, your IRD prepayment charge would increase. And the weight given to interest rates in determining the mortgage penalty matters more than the time left on your mortgage.
Variable rate mortgages come with the risk that you’ll pay far more in the future than you do today, but they typically come with a simple peanlty of only three (3) months’ interest.