Interest Rate Differential (IRD).

Understand how IRDs are calculated(at least the one’s we know…).

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Typically, mortgage penalties are calculated using the greater of three months interest or the Interest Rate Differential (IRD). But when it comes to astronomical mortgage penalties, the IRD penalty is the usual culprit. Therefore, it’s really important to understand how IRD penalties are calculated. Knowing what things to watch out for, particularly when you’re shopping around for mortgages, can save you a huge amount of money down the road.

There are three ways (that we know of) that IRD penalties are typically calculated and include the standard method, the discounted rate method and the posted rate method. The easiest way to explain how these methods work is to use an example.

So let’s assume you have a 5-year fixed rate mortgage with an interest rate of 3.6%. Your current mortgage balance is $200,000 and you have 26 months (just over 2 years) remaining in your term. You’re selling your home and need to get out of your current mortgage agreement.

The three months interest calculation is straightforward. All you do is take your annual interest rate (3.6%), convert it to a monthly rate by dividing by 12, and multiply it by your balance ($200,000) to get a monthly interest payment. Three months interest is then:

((.036/12) x $200,000) x 3 = $1,800

This is then compared to the IRD penalty. Many lenders use the standard penalty calculation, but others use the discounted and posted methods which can be easily manipulated to the lender’s advantage. While the IRD is supposed to represent the difference in interest payable on an existing mortgage vs. that payable on a replacement mortgage, you’ll see from this example that lenders don’t always make “fair” comparisons. Their ability to play games comes down to the use of two rates: the posted rate and the discounted rate (“special offers”). The posted rate can be used to inflate the IRD penalty artificially.

1) Standard IRD Penalty Calculation: This starts by comparing your existing mortgage rate (3.6%) with your lender’s current rate that most closely matches your remaining term. Since you have 26 months left in your term, this would be your lender’s two-year fixed rate, which we’ll say is 3.0%. The standard penalty is:

(your existing mortgage rate – lender’s current rate that most closely matches your remaining term) x mortgage balance x remaining term = (3.6% – 3.0%)/12 x $200,000 x 26 = $2,600

Since the standard IRD penalty of $2,600 is greater than three months interest ($1,800) you’d pay $2,600. Does that seem straightforward? It should be, but not all lenders make it so simple.

2) Discounted Rate IRD Penalty Calculation: This is where lenders can get a little sneaky. Instead of using the current rate that most closely matches your remaining term (i.e., the discounted rate that would be available to new borrowers), the lender uses the POSTED rate that most closely matches your remaining term (the two-year posted rate, which we’ll say is 3.3%) MINUS the original discount you got off the five-year posted rate. (Let’s say that when you took out your mortgage, the five-year posted rate was 5.1%, so the discount you received was 5.1% – 3.6% = 1.5%.) This is an unfair comparison, because short-term fixed-rate mortgages are often discounted much less than long-term mortgages: 0.3% vs. 1.5% in this example. But because the difference with your existing mortgage rate is much greater, the IRD penalty goes way up:

[your existing mortgage rate – (lender’s POSTED rate that most closely matches your remaining term – original discount you received) ] x mortgage balance x remaining term = [3.6% – (3.3% – 1.5%)]/12 x $200,000 x 26 = $7,800

Wow – your IRD penalty has just gone up from $2,600 to $7,800 because your lender uses the discounted rate penalty calculation rather than the standard penalty calculation. But as you’ll see from the next calculation, it can get even worse…

3) Posted Rate IRD Penalty Calculation: Here, the penalty is calculated using the difference between the five-year posted rate that was offered when you took out your mortgage (5.1%) and a “comparable posted rate”. How much you have to pay depends on how the comparable posted rate is defined. If the posted two-year fixed rate of 3.3% is used (as in the previous calculation), then the penalty will be the same:

(five-year posted rate offered when you got your mortgage – comparable posted rate) x mortgage balance x remaining term = (5.1% – 3.3%)/12 x $200,000 x 26 = $7,800

But let’s say the lender argues that the comparable posted rate is 3.1% rather than 3.3%. Then your IRD penalty goes up to a whopping:

(5.1% – 3.1%)/12 x $200,000 x 26 = $8,667

Ouch. You’ve just lost another $867.

The upshot is that you have to be wary of how IRD penalties are calculated when deciding on a lender. Using two sets of rates – posted and discounted – enables lenders to work the IRD penalty calculation in their favor.