Mortgage Penalties Explained.
Basic in’s and out’s of a mortgage penalty.
There are two types of mortgages: open and closed.
Open mortgages can be paid off at any time without penalties, but the cost of payment flexibility is usually higher interest rates.
In a closed mortgage, on the other hand, you agree to be bound by the terms and conditions of your mortgage until the mortgage term is complete. Terms often range from 6 months to 10 years.
While closed mortgages typically have lower interest rates, you cannot generally pay out a closed mortgage early without a penalty. The penalty is meant to compensate the lender for lost interest payments.
Some lenders even prohibit breaking a mortgage early unless in the case of an approved sale. However, most lenders allow you to pre-pay up to 20% of your original principle balance each year without penalty.
A mortgage penalty can come as a huge shock when you want to refinance or sell a property before the term is up, because you may be charged thousands or even tens of thousands of dollars by the lender. But just how are penalties calculated? In essence, you will pay the GREATER of:
– 3 month’s interest, which is based on your current mortgage balance and interest rate. For example, if you have a balance of $100,000 and a current interest rate of 5% per annum, then 3 month’s interest is approximately $1,250. This represents the interest portion of your next three mortgage payments.
– Interest Rate Differential (IRD), which is the difference between the interest you promised to pay and what the lender can earn today on a mortgage of your size (i.e., the balance). Building on the previous example, let’s say you have 2 years left on a 5 year mortgage, and the lender’s current posted 2-year rate is 3%. If you subtract 3% from your original rate of 5%, and multiply the difference by your mortgage balance of $100,000, then the IRD penalty is roughly 2 years x 2% per annum x $100,000 = $4,000.
So in this example, you would have to pay a $4,000 penalty. It should be noted that the Interest Act prohibits IRD mortgage penalties on terms over 5 years, after five years has elapsed. In such cases, a maximum 3-month interest penalty may apply.
One issue with IRD penalties is that the calculation of the penalty may be manipulated by lenders in order to maximize their profit. For instance, some banks will use posted rates for IRD calculations, while others use discounted rates, which increases the rate difference and therefore the penalty. If there are 18 months left in a term, some lenders will round up to two years to determine the comparison rate whereas others will use the lower one-year rate, which again increases the penalty.
Each lender has its own formula for calculating mortgage penalties, and the only way to find out what you might have to pay is to contact your lender for an exact quote.