Today I wanna talk about mortgage penalties and how and when they come into play within a mortgage.  The when part of the question is quite simple, so let's begin there.  Every mortgage has a maturity date (with the exception of home equity lines of credit), and if you sell your property or refinance your mortgage ahead of the maturity date, you are subject to a penalty from your mortgage provider (except for HELOCs and open variable/fixed mortgages).  And whether you like it or not, the concept of paying a penalty should not be surprising.  After all, a mortgage is a contract between you and the bank and if you’ve ever owned a cell phone you understand that there are consequences when you break your contract.  Same thing with mortgages, but at a much larger scale.  But, here’s the thing with the mortgage penalty...the convenient and commonly understood definition of it is that it equates to simply 3 months worth of interest payments, but there is clearly more to it than that.  For example, here’s one that I’ve recently encountered...on a $282,000 mortgage the three month interest penalty would equate to just under $2,500 if you broke the mortgage ahead of its maturity date.  But, what people are painfully finding out is that a mortgage penalty is subject to EITHER 3 months interest payments or interest rate differential, whichever is greater.  And this is where the shock value of a mortgage penalty lies.  For the example I just explained (a $282,000 mortgage with a 3-month interest penalty of $2,500), the IRD penalty equates to ~$22,000.  And lately, many of the fixed rate mortgages out there these days are racking up some huge IRD penalties.

So, let’s talk about Interest Rate Differentials...

When calculating your penalty based on an Interest Rate Differential, several other interest rates come into play (other than your actual contract rate) in the formula:

• The Contract Rate - this is the true interest/contract rate of your current mortgage
• The Comparable Rate - this is the prevailing market rate of the term that most closely matches your remaining term (in years)
• The Special Utility Rate - this is a rate factor that very often defies logic, but is built in to many big bank IRD formulas 

These rates are then inputted into the interest rate differential formula along with a couple of more clear cut variables (such as the remaining term of your mortgage in years and the balance of your current mortgage) and from these combined variables, the interest rate differential penalty is calculated.  Basically, the greater the spread between your current contract rate and the comparable rate, the bigger the IRD penalty.  

The entire objective of this formula is to ensure that a lenders profit margin is preserved throughout the agreed upon term.  So let's say you currently have a mortgage of 3.74% and have 2 years remaining on your 5 year fixed mortgage.  If you decide to break your current term (by either selling your home or refinancing your mortgage), you are now breaking a contract that promised to make payments at 3.74% (for 60 months) in a current market environment (as of today) that can fetch returns of only ~1.79%.  So, if you were a bank (or a business owner), think about that - the person you just lent money to, is surrendering their commitment to a contract you both mutually agreed to, thereby, forcing you to recoup your losses in a market that is far less valued than when the contract was signed.  And this is how the interest rate differential was born.

The variance of IRD penalty calculations from one lender to another could be quite significant as the comparable and special utility rates are products of the incumbent lender and are set as per their liking.  Generally speaking, big box brand name lenders have the highest yielding interest rate differential calculations, whereas the non-bank lenders tend to have more favourable formulas that yield a lesser spread.  

How to counter a massive mortgage penalty:

• Consider porting your mortgage (check out my past episode/blog for more details, Season 3 Episode 17)
• Look for a cash back mortgage to offset the penalty (some lenders offer cash back promotions that can help offset the penalty).  But proceed with caution and make sure you are aware of the terms and conditions associated with cash back mortgages.

Other IRD characteristics to be aware of:

• Open term mortgages (open variable rate terms, fixed open terms and HELOCs) are a safe haven from mortgage penalties.  Higher interest rates, but absolutely no discharge penalties
• Closed variable rate mortgages (99% of them) enforce only a 3 months interest penalty (no IRD penalty)
• If there is a possibility that you will sell your property within a 5 year period of when you secure your mortgage, you should strongly consider a variable rate mortgage or a shorter fixed term rate (this may eliminate any possibility of an IRD penalty)
• Always get an up-to-date confirmation of your break penalty as it could swing from being a 3 month interest penalty to an interest rate differential penalty in a very short period of time.  This is mainly a result of changing interest rates and the resulting spread 
• Never rely on an online penalty calculator (or your own mathematical inclination) to determine your precise break penalty figure.  ALWAYS call your lender and get it from the horse's mouth
• Be aware that in an interest rate changing environment your break penalty could sway from 3 months interest to IRD very quickly...and it can continue to change back and forth (as the prevailing interest rates, comparable rates and the utility rate are constantly changing)
• When shopping for your next mortgage, inquire about your lenders IRD Formula and compare with other lenders (or you could just call me and I can tell you all about them)

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