30 May

Not all banks calculate your mortgage penalty the same!


Posted by: Aneta Zimnicki

Most people break their 5 year fixed terms in 3 to 4 years on average.  That means your penalty will most likely be based on ‘Interest Rate Differential’ or IRD. Not all lenders are equal in that department….this is where many retail banks get you, playing around with ‘discounted rates’ and ‘posted rates’.  This could mean thousands and thousands of dollars more in penalties! Later in this blog, I show you the math and how the retail banks trick you.

Working with a good mortgage broker gives you the options of using other lenders that have simpler and less costly penalty calculations, and a broker can explain these calculations to you in everyday language.  When shopping for a mortgage, there is so much more beyond the surface than just an advertised interest rate!

Although borrowers don’t plan to break their mortgage, life may change unexpectedly. Situations like a new job location, family, divorce, illness, opportunity or need to refinance to access the equity. If you know upfront that you will not finish the typical 5 year mortgage term, consider getting a shorter term. Otherwise, you can benefit with the longer term, lock in the fixed rate and not have to worry about dealing with rising rates or complications with renewal offers.

Variable rate mortgage penalties are calculated differently.  It is simply 3 months interest. Sometimes borrowers go for variable not just because of rate, but this added flexibility of lower penalty costs. Penalties for fixed rate mortgages typically are ‘the higher of IRD or 3 months interest‘. It is prudent to assume IRD as the worse case scenario. There may be even higher penalty calculations with some niche products, for example ‘no frills’ mortgages, which lure you in with lower rate, you have to review the fine print.

Here is a sample IRD calculation, comparing the simple approach to the more convoluted approach. You can clearly see which approach is more profitable to a lender.

$300K mortgage balance at 5yr fixed 3.8% (at retail bank, posted rate is 5.3%, and you get 1.5% ‘discount’, at non-retail lender, posted rate is the same as your contract rate). Some borrowers may think, wow, I am special, I got a great discount! Then the lender uses it against you later.

2 years into mortgage, you need to break it. 3 years remaining on contract, lender looks at comparable ‘posted 3 year rate’). Assume retail bank shows 4.0% posted, non-retail lender shows 3.4%

What the retail bank does then is use 4.0% posted and deduct the original discount you received of 1.5%, giving net 2.5%, and really uses this unrealistic 2.5% as the basis for their penalty (cost of loss to them) calculation. But, in reality, no new mortgage client would be getting the 2.5% for that term if they went and got a new mortgage today.

Non-retail lender penalty calculation:
$300K  x (3.8% contract rate – 3.4% current rate matching term remaining) x 3 yrs   = $3,600 penalty

The retail bank calculation:
$300K  x  (3.8% contract rate – (4.0% current posted rate matching term remaining – 1.5% discount)) x 3 yrs  = $11,700 penalty

Note this is example only. Final penalty calculations are always confirmed by the lender.