Don't get caught flushing your money down the drain.
Many people think that the differences in how lenders calculate fixed-rate mortgage penalties are a non-issue now that rates have fallen to ultra-low levels. Nothing could be further from the truth if your mortgage is with a bank at a discounted rate.
Fixed-rate mortgage penalties are almost always calculated based on “the greater of three months interest or interest-rate differential (IRD)”. But there are key differences in the actual rates that our lenders use to calculate your IRD in comparison to the rates used by the Banks to calculate the same penalty. We’re not talking small potatoes here – The IRD calculations used by some prominent Banks can trigger a penalty that is more than four times what you would be charged by one of our preferred lenders.
Let’s start by assuming you have a current balance of $250,000 on a five-year fixed rate mortgage at 3.29%. We’ll also assume that you are three years into your term (with two years remaining) and that interest rates are the same when you break your mortgage as they were when you first got your loan.
First, we calculate the cost of three month’s interest, which we can quickly determine is $2,056 using the following formula:
3.29% X $250,000.00 X (3/12) = $2,056.00
We then compare this cost to the cost of your IRD penalty, which will generally be calculated in one of two ways: Standard, or Discounted.
The Standard IRD Penalty – Used by Our Preferred Lenders
When using a standard IRD penalty calculation, your lender starts by taking the difference between your contract rate (3.29%) and their current rate that most closely matches your remaining term. Since you have two years left on your mortgage, that would be the lender’s two-year fixed rate (we’ll use 2.99%, which is widely available today). The difference between these two rates is 0.30%.
The lender multiplies this difference (0.30%) by your mortgage balance ($250,000) and the time remaining on your mortgage (expressed as the number of months remaining on your mortgage divided by twelve).
Here is the complete formula:
(3.29% - 2.99%) X $250,000.00 X (24/12) = $1,500.00
That’s it. If you understand this example, then you have mastered the standard IRD calculation used by our preferred lenders.
But here is where a little knowledge can save you some serious money. Other well-know prominent Banks have tweaked their IRD calculations to skew the interest rates used in their formulas heavily in their favour, and as you will now see, that can have a huge impact on the size of your penalty.
The Discounted Rate IRD Penalty – Used by the Banks
When using the Discounted Rate Penalty, the Bank takes your contract rate and compares it to the posted rate that most closely matches your remaining term MINUS the original discount you got off of their five-year posted rate (which in this case is 1.95%). Here is the contract wording taken straight from a well-known bank’s website yesterday. I have underlined the key section:
[Your contract rate will be reduced by] the current interest rate that we can now charge for a mortgage term offered by us with the term closest to your remaining term. The interest rate will be our posted interest rate for the term minus the most recent discount you received.
In other words, this bank will take the discount they gave you off of their five-year posted rate and apply that same discount to the posted two-year rate they use in your penalty calculation. This tweak makes a big difference to the cost of your penalty and is blatantly one-sided because lenders don’t discount shorter-term fixed-rate mortgages nearly as deeply as they do their five-year terms (.30% vs. 1.95% using this same bank’s rate sheet as of today). This tweak is introduced only to artificially lower the rate used in your IRD penalty calculation.
Here is the complete formula:
(3.29% - 1.60%) X $250,000.00 X (24/12) = $8,450.00
I know. Ouch. Surprised? Don’t be. These inflated mortgage penalties generate substantial profits for the Banks who use them and when uninformed borrowers choose to negotiate directly with their bank, is it that hard to imagine that some of those bankers would tweak the fine print in their favour?
Don’t be a victim of the fine print, working with your own personal My Better Mortgage Specialist will get you into the right mortgage product for you and could potentially save you thousands.