How Much Will It Cost Me to Pay Off My Mortgage Before My Term Is Up? - Pre Payment Penalty
Interest rate differential (IRD) or 3 months interest?
Simply put, variable mortgages charge 3 months interest and fixed mortgages charge either 3 months interest or IRD, whichever is greater.
Interest Rate Differential
To put it bluntly, the Interest Rate Differential Amount is often a shocker for borrowers looking to prepay their mortgage. When borrowing money on a mortgage, the borrower is entering into a contract with the lender to pay the lender interest at a set rate for a set term. Lenders protect themselves by charging a prepayment penalty to a borrower that wants to break the mortgage contract. This amount is the amount a lender will lose over the remaining term on a closed mortgage by receiving the mortgage funds back, and having to lend out to a new borrower at a lower rate of interest.
Let’s use an example to show how this penalty amount could be crippling for a borrower.
Let's look at an example with a home buyer Kim. Kim locked in to a 5-year fixed mortgage rate at 5.49%. Now, a little over 2 years later, Kim wants to pay off some debt using her homes equity. Kims mortgage amount is currently $300,000 and she is considering refinancing.
Step 1: Determine your current mortgage principal, and original mortgage rate:
$300,000 mortgage 5.49% original mortgage rate
Step 2: Determine the length of time remaining in your mortgage:
=5 years - 2 years, 1 month = 60 months - 25 months = 35 months (close to 3 years)
Step 3: Determine your lender's current mortgage rate with a term equal to your remaining term:
current 3-year fixed rate = 3.89%
Step 4: Subtract the lender's current mortgage rate from your original mortgage rate:
= 5.49% - 3.89% = 1.60%
Step 5: Multiply the difference in interest rates by principal and divide by 12 months:
=[1.60% * $300,000] /12 months =$400/month
Step 6:Multiple the monthly fee by the number of months remaining in your term:
= $400 * 35 months - $14,000
Kim would owe her lender $14,000 to cancel her mortgage contract.
There is good news though. The IRD amount will only apply when the posted rate at the time the funds are borrowed is higher than the posted rate when the funds are repaid. This means that when rates start rising and the posted rate at the time the funds are borrowed is less than the posted rate when the funds are returned, the lender is happy to have the mortgage funds back so that it can lend it out at a higher rate and make more funds off the new borrower. So, always compare these rates when considering prepaying your mortgage in full so that you are not caught by the nasty IRD prepayment penalty.
If the IRD is lower than the 3 months interest, the lender will charge the borrower 3 months interest.
3 Month Interest Penalty
This penalty is usually much cheaper than the IRD. Its easy to calculate and most lenders will use your contract rate. Double check with your mortgage broker but as I write this, I believe only CIBC will use their posted rate. Every other lender uses your contract rate.
Lets look at an example of how the 3 months interest penalty is calculated
The 3 month interest penalty is more straightforward than the interest rate differential. Simply take your current mortgage principal and multiply it by your current mortgage rate, divide by 12 months to get a monthly penalty and multiple it by 3 to account for three months.
Let's consider the same example, where Kim locked in to a 5-year variable mortgage rate. Kim's mortgage balance is $300,000 and she is considering refinancing.
Step 1: Determine your current mortgage principal
$300,000
Step 2: Determine your original mortgage rate: 5.49%
Step 3: Determine one months interest payment: [$300,000 * 5.49%]/12 months = $1,372.50
Step4: Multiply one months interest by 3$1,372.50 * 3 months = $4,117.50
Result 3 months interest penalty$4,117.50
These penalties are only charged if you sell (without porting your mortgage) or if you want to refinance. It is important to understand this before you enter any contract, you may not ever need to exit the mortgage contract early but life is unpredictable at times and it’s best to be informed and plan ahead.