4 Mar

Understanding Mortgage Penalties

General

Posted by: Gleb Tchani

     One major concern we address when entering a mortgage contract are the penalties.  We have all heard about people having to pay $10,000 or $15,000 in penalties.  Some times, the lender will offer you a discount if you start another mortgage with them, some times they will offer you to put it into your new mortgage, some times you just have to pay.  The bottom line with all of these alternative is that, you are potentially losing a substantial amount of money yet no one really prepares you for it when you look over the contract.  We all know that there are two types of interest rates: variable and fixed.  I will try to give you a better understanding of what you may potentially have to deal with.

     The penalty calculations of a variable rate mortgage are straight forward; it is three months interest.  For example: with an outstanding balance of $300,000 and a mortgage rate of 2.5%, you simply multiply annual rate by the remaining balance and divide it by 4 to come to a 3 months interest.  $300,000 x 2.5% ÷ 4 = $1,875.00.

     Things get a little more complicated when we have fixed rate.  To avoid confusion, I will try to go into as little detail as possible but there is still a lot of important factors.  I really think, between the links and the explanations, it will be worth a couple extra minutes of your time to stick through the whole article.  A small note here; most of us do or, will end up obtaining a fixed rate mortgage as it is much easier to qualify for.  I will have another article dedicated to the qualification process.  Here is the typical contract penalty description for a fixed mortgage.

 

The Early Payout Penalty is equal to the greater of 3 months simple interest or the Interest Rate Differential Amount:

  • 3 months simple interest. This is calculated by applying your current Interest Rate being charged on your Mortgage to the outstanding Principal balance of your Mortgage, for a 3 month period.
  • Interest Rate Differential Amount. This is calculated by applying the difference between:

a)     The Interest Rate being charged on your Mortgage, and

b)     The current best rate in effect at the time, being charged by us on a loan with a term that is closest to the remaining term of your Mortgage.

This rate difference (between a and b) is then applied to the outstanding principal balance of your Mortgage, for the remaining term of your Mortgage.

 

     What really becomes a problem is that the Interest Rate Differential (IRD), while under the same name, is a different formula from lender to lender.  In this above example, the explanation of IRD is actually what it logically should be with every institution.  Unfortunately, as you will see below, that is not the case.

     To show you the difference, I have taken 5 major banks and 2 lenders that I like to deal with and reviewed their penalty calculators.  I applied the same scenario to each calculator and tried to find or derive the (IRD) formula they use.  With a few institutions, I was not able to find or explain the calculations so I just used the answer from their online calculator.  For each institution I provided a link to their mortgage penalty calculator.  For each scenario, I assumed a remaining term of 3 years of the original 5-year mortgage and a remaining balance of $300,000

     Let’s start with major banks.  When selling mortgage products, all 5 major banks use a strategy of posted rate and a discount.  Other lenders use this concept as well, but usually only for qualification purpose.  When you walk into any of the big 5 banks, you will see their posted rates.  You can also find them on their respective websites: RBC, BMO, CIBC, Scotia, TD.  From that rate, you get a “discount” and come up to a discounted rate, some banks have that specified right there, on the same page with posted rates (side note: the discounted rates, are usually still above what’s available in the market).  That discount you receive is one of the factors that affects your mortgage penalty when it comes to that point.  In fact, as you can see from information I provided below, the higher the discount, the higher penalties you can expect.  I could only confirm it for CIBC, Scotia and TD but I have a feeling RBC and BMO also have rate discount incorporated into their formula.

     The other 2 lenders I have included are MCAP and First National.  The example description I have used above is from an actual MCAP commitment.  As penalties are probably the next most important shopping factor after the actual rate, I like to chose lenders that have a reasonable and a clear explanation of their IRD calculations.

     As you can see below, the highest penalty came out to be $11,438.68 by BMO.  Out of the 5 major banks, RBC had the lowest penalty at $7,713.39 and First national had the lowest penalty of all at $4,112.37.  4 out of 5 major banks came out with a number above $10,000. 

     As I mentioned, the reasonable number should be what we see calculated by MCAP, $5,400.  You can see the calculation below, and, it matches the description given in the example above and, the $5,400 is almost half of what you would pay at most major banks.

RBC

  • Penalty Calculator: Link
  • Penalty amount using online penalty calculator provided by the lender:  $7,713.39
  • Formula:  Could not be located

BMO

  • Penalty Calculator: Link
  • Penalty amount using online penalty calculator provided by the lender:  $11,438.68
  • Formula:  Could not be located

CIBC

  • Penalty Calculator: Link
  • Penalty amount using online penalty calculator provided by the lender:  $11,250.00
  • Formula: 

Scotia

  • Penalty Calculator: Link
  • Penalty amount using online penalty calculator provided by the lender:  $11,250.00
  • Formula: 

TD

  • Penalty Calculator: Link
  • Penalty amount using online penalty calculator provided by the lender:  $11,250.00
  • Formula: 

MCAP

  • Penalty Calculator: Link
  • Penalty amount using online penalty calculator provided by the lender:  $5,400.00
  • Formula: 

First National

  • Penalty Calculator: Link
  • Penalty amount using online penalty calculator provided by the lender:  $4,112.37
  • Formula:  Could not be located
Have any more questions?  Do not hesitate to contact me, I would be very happy to help.