Mortgage penalty explained

It has been over a month since my last entry. My life has been crazy-busy this year and I really needed a break. I took time-off work and I also had family visiting, which was exactly what I needed. I realized I also needed a break from my daily routine.

I am definitely more settled in my condo and new city. I enjoy living there and I know I made the right move by selling my previous condo.

Going through the madness that is real-estate in Vancouver, I have to write another post on the subject of mortgage penalty.

In Canada, when you pay-off your mortgage early, lenders have the right to charge you a penalty for doing so. Mortgages are a huge business here, and even with low-interest rates, lenders are turning massive profits.

The penalty you will be assessed depends on whether you have a fixed rate or a variable rate mortgage. As indicated in their names, the interest rate on a fixed rate mortgage will remain the same during the term of the mortgage. A variable rate, on the other hand will fluctuate.

This is because the interest rate on a fixed mortgage is determined by the bond market whereas the variable rate is determined by the prime rate set by the Bank of Canada.

This also explains why there are 2 different penalties: 3-month interest or Interest Rate differential -IRD-.

For a variable rate mortgage, the penalty will always be 3-month interest, as mandated by the National Housing Act.

For simplicity, let’s say you have \$ 100 000 left on your mortgage with an interest rate of 4.00%. The penalty would be:

4.00  X  100 000  X  (3/12)  = \$ 1 000.00.  Pretty straightforward.

There are 2 different ways of calculating the IRD. One could impact you in a significant way.

Once again, for simplicity, we will assume  a \$ 100 000 mortgage at 4.00 % with 24 months remaining on the term.

With a standard IRD calculation, the lender will take the current interest rate for a 2-year term fixed rate mortgage, matching the 24 months left on your mortgage.

Let’s say the rate on this is 2.75%. The lender will the calculate the difference between this rate and your mortgage rate. i.e 4.00 – 2.75 = 1 .25.

The penalty is then calculated as follow:

100 000  X (1.25 /12)  X  24  = \$ 2 500.00.  More than double the 3-month penalty!

A few lenders use a loophole in the Interest Act for the second way to calculate the IRD. The Act does not specify which rate should be used to calculate the penalty.

Let’s keep the same numbers as above. Some lenders use the posted rates instead of the contract/discounted rates, i.e. the rates you actually pay or would pay.

You obtained a rate of 4.00% but the posted rate on the day you got your mortgage was 5.25 %. The lender gave you a discount of 1.25 %.

The posted rate for a 2-year mortgage is now 3. 00%.

The lender will use an IRD factor of 2.25, i.e. 4.00 – (3.00 -1.25).

In terms of penalty, it amounts to:

100 000 X (2.25 /12) X 24 = \$ 4 500.00, more than quadruple the 3-month penalty!

I know all these calculations look boring but it is crucial to understand how your lender calculates your mortgage penalty if you have a fixed rate mortgage.

I was lucky that my previous lender did not use the posted rate. They charged me a 3-month penalty as it was higher than the IRD. Had they used the posted rate, I would have paid over \$ 4 000 in penalty. When I signed the documents, I did not pay attention to this.

Most people don’t, unfortunately.

For my second mortgage, I went with a variable rate.