Escalating penalties

One discussion I have with my clients upfront is whether they want to choose a fixed rate or a variable rate.

Most of my clients opt for a fixed rate mortgage because they want the security of knowing what their mortgage payment will be in case rates go up.

Why would someone choose a variable rate mortgage?

The most important consideration is pre-payment calculations.

If you choose a variable rate mortgage, the maximum penalty your lender can charge should you choose to pay the mortgage in full at any point before your scheduled maturity date is three month’s interest.

If you choose a fixed rate mortgage, you are looking at the greater of three months’ interest on the balance you currently owe or the interest rate differential (IRD).

What is the IRD? Here is the definition from the Financial Consumer Agency of Canada’s website.

The interest rate differential is the difference between the interest rate on your current mortgage term and today’s interest rate for a term that is the same length as the remaining time left on your current term.

Why is the penalty calculation important and when does it come in to play?

The penalty calculation is important when you need to break your mortgage prior to your maturity date. All mortgages are not created equal when it comes to paying in full ahead of schedule.

When I talk about “breaking” your mortgage, I mean paying it out in full before the end of your mortgage term.

Why would you break your mortgage before the maturity date?

Some of the common reasons we see are:

• Change in financial situation / financial hardship so forced to sell your home
• Change in marital status / neither keeping the home
• Moving and choosing not to buy in the new location
• Refinance to renovate or consolidate debts
• Switch to a different lender for lower rates
• Selling and purchasing a new home of a type that your current lender won’t consider (i.e.: log home, rural property, remote location)

Using the exact same information for each lender, I went to their online prepayment calculators to see what their prepayment penalties would be. Assuming:

• A current mortgage balance of $400,000
• Contract interest rate of 3.04%
• Maturity date of Aug. 4, 2023
• Current rate for a similar term of 2.09%

It is interesting to see how the penalties vary from one lender to another.

Lender                       Fixed Penalty                   Variable Penalty

First National             $7,272.30.                         $3,040

RFA/Street Capital    $8,464.65                          $3,040

RBC                            $14,141.70                        $3,040

TD                               $18,315.83                        $3,040

My point in sharing this is not in any way to slam a particular lender. I often place clients with TD. They have great products and will look at applications that other lenders may not.

As rates have plummeted over the last few months, we have seen many lenders drop their rates for their one to four year mortgage terms.

This effectively increases your penalty if you are breaking your term early. In some cases I’ve heard about this has doubled or even tripled the mortgage penalty from the time people started the process of refinancing or selling their home but moving to a different lender with their purchase.

One of my clients was provided an estimate of his penalty which was $1,900. Estimates always come with the qualifier that this amount is subject to change depending on any changes to interest rates.

When his house sold six weeks later, he was not happy to learn that his penalty had climbed to $9,967 due to the drop in interest rates in the meantime.

The saving grace for this client was that he had significant equity in his home to the added $8,000 did not leave him short for the down payment on his new home.

Added bonus is that the rate on his purchase has also dropped form 2.34% to 1.99%, so he will save far more than the $8000 over the next five years.

When you are wrapped up in the excitement of buying a new home, the last thing you are thinking about is having to break your mortgage early.

Pre-payment penalties should be a conversation you have with your mortgage person.

If you are part way through the process of buying and selling a home or waiting for a switch or refinance to close, double check your penalty to make sure it does not affect your new mortgage.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.