Did you know? 80% of Canadians don’t finish their mortgage term.
Why is that? Well, it’s because life happens. Circumstances change. Marriages. Divorces. Children. Some people will refinance to take the equity out of their home for renovations, some will refinance to consolidate date. Sometimes even buying a new home can cause you to break your mortgage. Whatever the reason, when you break the terms of your mortgage before the maturity date, you’ll have to pay a penalty.
But it’s not all terrible. Sometimes it’s worth it to pay the penalty. For example, if you’re breaking your mortgage to obtain a lower rate, you could be savings yourself thousands of dollars in interest costs that would far outweigh the penalty costs. Ask your mortgage broker to calculate the savings over the penalty costs and you may come out ahead.
When shopping for a mortgage, the penalty provision is one of the most important factors to consider, if not the most important. There are 3 kinds of penalty calculations to consider:
3 Months Interest Penalty (Variable Rate Mortgages)
This is a common type of penalty used. This is the only penalty that can be used if your mortgage is a variable or adjustable rate mortgage. The calculation is quite simple.
Estimating three months’ interest:
Say your remaining mortgage balance is $300,000 and your interest rate is 3%. If you break your term, you will pay a penalty of $2,250 by the 3 month interest calculation.
$300,000 x 3% = $9,000 / year
$9,000 / 12 months = $750 / month
$750 x 3 months = $2,250
Pretty simple, right?
Interest Rate Differential (IRD)
Now, in contrast, the IRD calculation is very complex. The result of the calculation depends on market factors such as the bank’s posted rate, any discounts you received when you first obtained your mortgage, the number of months remaining on your term, and of course, your mortgage balance. When you hear of outrageous mortgage penalties, it’s usually the IRD calculation to blame.
Another reason why IRD penalties can cost you thousands, even tens of thousands of dollars is because not every bank calculates their IRD penalties differently. It’s important to know HOW the lender calculates the IRD. Generally, IRD penalties are used when you break a fixed-rate mortgage. Many banks base the penalty on the posted rate rather than your actual contract rate. This has a large impact on your penalty cost. Pro tip: lenders that use the contract rate to calculate penalties are far less dangerous. This is why it’s so important to have your mortgage broker explain the penalty provision to you. If you’re getting a super low mortgage rate but the IRD penalty can potentially cost you more in the long run, you might want to see what other options are available to you.
Flat Fee Penalties
There are some mortgage products and some mortgage lenders that will charge a fixed percentage of your remaining balance when break your mortgage, no matter how long remaining on your term. For example, 2.75%. So with a $300,000 remaining mortgage balance, your penalty would be $8,250.
Open Mortgage (No Penalty)
Some mortgage products are open. This means there is no breakage penalty at all. However, these products are limited to 6 month terms and will come with much higher rates.
Why are there penalties anyway?
When you enter into a mortgage agreement, you also sign into a term. Anywhere from 1 year to 10 years. When you break the term, a penalty is charged to compensate the lender for the interest payments lost.
Again, mortgage penalties don’t necessarily have to suck. The important thing is that you know what your penalty provisions are before signing on the dotted line. So if you ever have to break your mortgage, you can better prepare yourself for the cost of breaking the mortgage. If you know what your penalty provisions are, it won’t come as an unwanted surprise.