A mortgage penalty is incurred when you make a change to your mortgage before your term is up. This could be paying it off in full due to selling your home, or it could be for allowing a refinance to change lenders, mortgage rate, mortgage amount, or amortization.
In Canada, banks and mortgage lenders calculate this penalty one of two ways: 3 months interest or interest rate differential (IRD). Which one you pay will depend on your lender, mortgage product, and the duration of your term. For example, while the penalty associated with a variable mortgage rate is always 3 months’ interest, the penalty associated with a fixed mortgage rate is often the greater of 3 months’ interest or interest rate differential (IRD)
Three months interest vs. interest rate differential (IRD) refinance penalty
| 3 months interest | Interest Rate Differential (IRD) | |
|---|---|---|
| Description | Penalty is the equivalent of three months interest on current mortgage principal | Penalty is the interest lost if your lender were to turn around and lend the funds at today’s rates |
| Mortgage Type | Variable and Fixed | Fixed only |
| Formula | [Mortgage principal * original interest rate] / 12 * 3 | [Original mortgage rate1 – current mortgage rate2] * Principal / 12 * months remaining in current term |
| When do you pay? | All interest rate environments | Declining interest rate environments, or when the bank uses Posted Rates in addition to Discount Rates. |
How do you calculate your interest rate differential (IRD) penalty?
Interest rate differential or IRD takes the difference between the interest rate attached to your mortgage and compares it to the current interest rate charged by the lender. Let’s look at an example with a home buyer Sarah. Sarah locked into a 5-year fixed mortgage rate on February 1st, 2019 with ING. It is now March 1st 2021, Sarah’s mortgage balance is $300,000 and she is considering refinancing.
| Step 1: Determine your current mortgage principal, original mortgage rate and provider | $300,000 mortgage 5.49% original mortgage rate Mortgage provider is ING |
| Step 2: Determine the length of time remaining in your mortgage | = 5 years – 2 years, 1 month = 60 months – 25 months = 35 months (close to 3 years) |
| Step 3: Determine your lender’s current mortgage with a term equal to your remaining term | ING current 3-year fixed rate = 3.89% |
| Step 4: Subtract the lender’s current mortgage rate from your original mortgage rate | = 5.49% – 3.89% = 1.60% |
| Step 5: Multiply the difference in interest rates by the principal and divide by 12 months | =[1.60% * $300,000] /12 months =$400 |
| Step 6:Multiple the monthly fee by the number of months remaining in your term | = $400 * 35 months – $14,000 |
Interest Rate Differential Calculation at Major Banks vs Credit Unions and Non-Bank Lenders
It’s worth noting that while some lenders use the current posted rate (without any discounts) when calculating prepayment penalties, others may offer prepayment options that can reduce the penalty if exercised.
Table 1: Prepayment Penalties – Major Banks vs. Non-Bank Lenders
| Lender | Penalty (CAD) | Website |
|---|---|---|
| Major Banks | ||
| Royal Bank | $7,676.21 | http://bit.ly/1zbelYv |
| Scotia Bank | $8,395 | scotiabank.com |
| CIBC | $9,998.03 | cibc.com |
| TD | $8,682.50 | tdcanadatrust.com |
| Non-Bank Lenders | ||
| First National | $2,250.00 | firstnational.ca |
| Street Capital | $2,520.00 | streetcapital.ca |
| CMLS | $3,120.00 | cmls.ca |
Example Calculation: Monoline vs. Bank Penalty
Consider the following example for comparing penalty calculations between a non-bank lender (Monoline) and a major bank:
Current Rate & Remaining Term: 23 months and 3.49%
- Monoline Penalty Calculation:
- Subtract Current Posted Rate Closest to Remaining Term: 3.74%
- Divide by 12 months/year
- Multiply by Time Left on Mortgage & Balance
- Result: IRD Penalty is $0, so a 3-Month Interest Penalty Applies: $3,490.00
- Bank Penalty Calculation:
- Subtract Current Posted Rate Closest to Remaining Term Minus Original Discount: 3.24% – 1.3% = 1.94%
- Divide by 12 months/year
- Multiply by Time Left on Mortgage & Balance
- Result: IRD Penalty is $11,883.33
In this case, the Monoline lender incurs a 3-month interest penalty of $3,490.00, while the major bank faces an IRD penalty of $11,883.33, leading to savings of $8,393.33 by choosing the Monoline lender.
How do you calculate the 3 months interest refinance penalty?
The 3-month interest penalty is more straightforward than the interest rate differential. Simply take your current mortgage principal and multiply it by your current mortgage rate, divide by 12 months to get a monthly penalty and multiple it by 3 to account for three months. Let’s consider the same example, where Sarah locked in to a 5-year fixed mortgage rate on February 1st, 2019 with ING. It is now March 1st, 2021, Sarah’s mortgage balance is $300,000 and she is considering refinancing.
| Step 1: Determine your current mortgage principal | $300,000 |
| Step 2: Determine your original mortgage rate | 5.49% |
| Step 3: Determine one months interest payment | [$300,000 * 5.49%]/12 months = $1,372.50 |
| Step 4: Multiply one months interest by 3 | $1,372.50 * 3 months = $4,117.50 |
| Result 3 months interest penalty | $4,117.50 |
Minimize your refinance penalty by taking advantage of your pre-payment options
Most mortgages come with pre-payment options which allow you to put a lump sum against your mortgage each year and/or increase your monthly payment. Putting a lump sum against your mortgage and increasing your monthly payments both have the ability to decrease your mortgage principal and therefore your penalty. Therefore if you are refinancing now or in the near future, it is important to take full advantage of these.
Understanding the differences in penalty calculations between major banks and non-bank lenders is crucial when considering breaking your mortgage before the term ends. By carefully comparing the penalties associated with each option, borrowers can make informed decisions to minimize their financial burden. It is advisable to consult with a mortgage professional to fully comprehend the terms and conditions of your mortgage contract and determine the best course of action based on your specific circumstances.
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