With the frenzy surrounding the recent mortgage deep discounts, I have been fielding a lot of calls from clients trying to make sense out their mortgage payout penalties on the existing mortgages. Here is a little summary to help with your decision.
- To understand why banks charge penalties, you have to step back and take a look at the bigger picture. For example, when you sign a mortgage for 5 year term, at say 4%, you are promising the bank a revenue stream for 5 years at 4%. They turn around and re-invest your “promise to pay” on the basis that this revenue will remain for a 5 year period. If you decide to break the term, the bank is no longer receiving the revenue, but remains committed to the re-investments…so a penalty is charged…or in bank terms, they charge the replacement cost of funds.
- The penalty charged is usually the greater of 3 months’ interest or the interest rate differential (IRD). An estimate for the 3 months’ interest is approximately 2 months’ worth of mortgage payments. The IRD is a little more complicated to explain. The IRD is the bank’s loss of interest for the time remaining in the term. So if you take a 5 year fixed and pay it off after 3 years, either from refinancing, or by sale, the bank will calculate the IRD by comparing your rate, with the current rate for 2 years, and charge that on the balance to the end of the term. The banks are covered to recover their interest no matter what.
- The penalty calculation of the greater of 3 months’ interest or the IRD is an industry standard in Canada. This is the penalty calculation that most of our institutional lenders apply. When you are in a closed variable rate mortgage, only the 3 month interest penalty applies, the IRD is not applicable.
- When you are in a term that is longer than 5 years, under the Bank Act, the maximum penalty that can be charged is 3 months’ interest.
- Most banks will offer either fixed rate open financing or variable rate open financing, but you pay for the privilege of the open feature. This is usually by way of a higher interest rate. Home equity lines of credit are open financing, but are not available in certain situations, ie high ratio financing.
- If you are selling your home and buying another and you do not want to pay the penalty, you can usually “port” your mortgage to the new property. If you keep the same rate, and same maturity date, you often end up with a “blended rate” if new funds are needed. If you are downsizing, some banks will take off your annual prepayment allowance to help reduce the penalty.
- You really need to look at the interest cost differences
between your current rate and the new rate for the time left in the term, not a new 5 year window. There is a key part of information that is needed to make the right choice…but absolutely no one has the information today…and that is what interest rates will be in the future. If rates are the same or lower at the time of your original maturity date, then you may have been better off to wait it out. If interest rates are higher than at your original mortgage maturity date, then you may be very happy that you did an early renewal.
- Other factors that play a role in the decision, but are harder to put a monetary value on, are the effects on your monthly cash flow. Even though you may not be saving anything over the course of the remaining term, you may benefit from a refinance or debt restructure at a lower rate that could make your life easier & more manageable. Life changes are often an influencing part, as in growing family, renovation, or kids going off for post secondary education. All of these are important events that you can not put a monetary value on, and may be worth the costs to change.
