How is the Pre-Payment Penalty Calculated for a Fixed Mortgage? Understanding the IRD (Interest Rate Differential) Calculation
A mortgage is a binding contract that comes with its own set of terms, conditions, and responsibilities for both you and your lender. When you sign on that dotted line, you're essentially agreeing to abide by those terms for the duration of the contract. But life is unpredictable, and sometimes, you might find yourself needing to make significant changes to your mortgage before the term is up. Can you do that, and what are the potential penalties involved? Let's delve into this!
First things first, the answer to whether you can break your mortgage contract before its scheduled end is yes, you can. Most mortgage lenders will permit this, but they'll want something in return – compensation, in the form of what's known as an Interest Rate Differential or IRD. In simple terms, when you initially locked in your fixed-rate mortgage, you had a specific interest rate, say xx.x%. Now, if they were to lend the same amount to someone else today, they'd charge a rate that's 1% lower. So, they want to make up that difference. Sounds pretty straightforward, right? Well, as with most contracts, the devil's in the details, specifically in how the IRD is calculated. Let's explore some of the methods used for IRD calculations.
Method "A" - Posted Rate Method (Commonly used by major banks and some credit unions)
This method employs the Bank of Canada's 5-year posted rate to determine the formula for calculating the penalty. It also takes into account any discounts you might have received when you first set up your mortgage. You've probably seen these discounts on the bank's website or at your local branch. The final penalty, in this case, is calculated as the greater of 3 months' interest or the IRD. Here's what it looks like in practice:
Bank of Canada Posted Rate for a five-year term: 4.89%
The discount you received: 2%
Resulting in your actual contract rate: 2.89% for a five-year fixed-term mortgage.
Now, let's say you want to exit your mortgage after just 2 years, leaving 3 years remaining on the contract. The posted rate for a 3-year term at that time is 3.44%. Subtract your discount from that rate, and you get 1.45%. Your IRD is then calculated as follows:
2.89% - 1.45% = 1.44% IRD difference x 3 years = 4.32% of your mortgage balance.
On a $300,000 mortgage, this would translate to a penalty of $12,960. For most people, that's a substantial amount to pay.
Method "B" - Published Rate Method (Commonly used by monoline lenders and most credit unions)
This method is generally more favorable because it uses the lender's published rates, which are often closer to the rates you see on their websites. Let's illustrate with an example:
Your current rate: 2.90%
Lender's published rate: 2.60%
Time left on your contract: 3 years
The equation here is: 2.90% - 2.60% = 0.30% x 3 years = 0.90% of your mortgage balance. This results in a much more reasonable penalty. On a $300,000 mortgage, you'd be looking at a penalty of only $2,700.
The above scenarios assume that the borrower has good credit, documented income, and a standard residential property. Additionally, these calculations pertain to fixed-rate mortgages, not variable ones. In the case of variable rates, if you need to break the contract, typically you'll only incur a penalty of 3 months' interest; no IRD applies.
We are committed to ensuring that you make an informed decision when selecting a lender. While we aim to secure the best possible rate for you, we also want to ensure your overall financial well-being.