Fixed rate mortgage penalties, variable rate mortgage penalties, bank penalties versus non-bank penalties – understanding the differences of each is crucial when choosing your mortgage. When clients take on a mortgage many believe that they will stay in their mortgage for the full term and therefore don’t consider the importance of what a penalty would be to break their mortgage.
Clients want to break or payout their current mortgage for many reasons; to get a better rate, to refinance for debt consolidation, for investments or a 2nd property, for marital separation of assets, or to pay the mortgage off in full (inheritance, employment bonus, lottery winnings). The expectation of most clients is that they will have a 3 month interest penalty to pay in the process of breaking their current mortgage. Although this would apply to some mortgages others could potentially have a much greater penalty to cover dependant on many variables and the type of mortgage they choose. Variables would include; their outstanding mortgage, their term remaining, their current mortgage rate, the existing mortgage rate at the time of breaking , and if posted rates are applicable.
For some mortgages there are no penalties to be paid such as an open mortgage or a home equity line of credit but these mortgages typically come with a much higher rate than closed mortgages.
With closed mortgages the calculation for penalties can differ dramatically from a bank versus a non-bank lender. Do you often wonder why bank’s have what is called “posted rates” on their websites? They are usually much higher than the going rate so what is the purpose for them? They are used to calculate your penalty using an Interest Rate Differential calculation. Compared to non-bank lenders, the banks have the highest penalties when it comes to calculating this IRD and it all comes down to their usage of the posted rate.
Let’s take an example: A young couple wants to break their current closed fixed rate mortgage to sell their home They are with a bank currently and have 2 years remaining on a 5 year closed fixed rate of 2.64 with a balance of $375,000. The posted rate used to calculate the IRD would be 4.74%. In this example, this couple would be looking at paying an IRD penalty of $14,250. This amount is substantial.
On the other hand, let’s take a look at what the IRD penalty would be with a non-bank lender. For the same example instead of using the “posted rate” to determine the penalty, a non-bank lender would use their current rate. In this case they use the current 2 year fixed term rate of 2.19% since the clients have 2 years left on their mortgage. The IRD penalty that the clients would have to pay would be $3,375.
The bank penalty is $10,875 more than the non-bank lender! That is an incredible difference. This should be a important consideration when choosing a lender with if you are choosing a closed fixed rate. The bank is always going to calculate a much higher prepayment penalty than a non-bank lender.
For fixed rate mortgages the rule of thumb is the IRD or 3 months interest – whichever is greater. We most often see it would being the 3 months interest amount the closer you get to your maturity date.
For most closed variable rate mortgages, a penalty of 3 months of interest would apply as a penalty.
There are deeply discounted mortgage rates that are available but there are catches to obtaining these low, low rates. Most often the restriction has to do with a penalty and in some cases the penalty can be as high as 3% of the outstanding mortgage. Taking the example above, the penalty would be $11,250 at 3% of $375,000. Still less expensive than the bank’s penalty but a significant amount to have to pay. This is where fully understanding the mortgage that you are receiving is of utter importance.
Feel free to contact us should you have any questions or concerns.
Kim Gibbons, Mortgage Superhero ®
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Your Toronto Mortgage Broker