Most clients choose a closed mortgage when they purchase or refinance a home because open mortgages have a higher interest rate. With a closed mortgage, you are in a contract. If you want to break the contract, then there will be a penalty.
I'm often asked by clients, "how do mortgage penalties work in Canada?"
For closed fixed mortgages, the penalty is calculated as the greater of three months interest or the Interest Rate Differential (IRD). The IRD is calculated as the difference between your rate and current going rates. If your rate is higher than current rates, then you pay for the difference over the remaining term.
For variable rate and adjustable rate closed mortgage, the penalty is typically calculated as 3 months' interest. Some mortgages are set up with restrictions and in those cases, there may be other penalties that apply. Each of these may be different based on the contract. It's important to read and understand the contract before you sign.
In this article, I'm going to focus on closed fixed mortgage penalties. I will review the different way's that lenders calculate the penalties and what to look for.
Before I go into detail, let me explain why lenders charge penalties.
Why do banks and other lenders charge penalties?
When a lender provides you with a mortgage, they are using investors money. They may be the investor, but in many cases other clients, banks, pension plans, etc. could be the investor.
Lenders will package the mortgages that they fund over a period of time into $10 million bundles, for example. This $10 million bundle is insured (through one of Canada's Mortgage Insurers) and is then sold to an investor, the lender still administers the payments, etc..
The investor is guaranteed a return, by the lender, on that investment over a set period of time. The lender has therefore entered into 2 contracts. One contract with the client who used the mortgage to purchase a home and another contract with the investor.
If the client sells his home, the lender can no longer hold the home as collateral and the mortgage is paid off. This causes an issue for the lender because this money is no longer receiving interest. The lender has to continue to pay the investor.
Because of this, lenders will charge a penalty to clients who want to break the mortgage early. The idea behind the penalty is to ensure that the lender can continue to repay the interest to the investor.
One option a lender could explore would be to replace the old paid out mortgage with a new mortgage that's been recently set up. If that new mortgage is at a higher interest rate than the original, then the lender more than covers the investor's return. The lender will charge the original client a 3-month interest penalty to pay administrative fees for this exchange.
If however, the new mortgage is at a lower rate than the original, then the lender will be losing money every single month until the end of the original term.
The lender won't stay in business very long if they are paying out more than they receive, therefore they will want to cover the difference. That's how the Interest Rate Differential (IRD) penalty was created.
For example, the replacement mortgage could be 1% below the original mortgage. If there are 3 years left on the original mortgage, then the lender would be paying the investor 1% more than the lender receives. The lender would pay this out over 3 years. That could be a lot!
By charging the original mortgage holder a penalty to break the contract, the lender isn't losing money on the original contract. The lender will stay in business over the long term and continue to help more clients buy a home and investors generate a reasonable return.
This all seems fairly straight forward. Sort of. The complications come when we compare how IRD is calculated by different lenders.
IRD (Interest Rate Differential) Mortgage Penalty Calculation Examples
The mortgage penalty calculations for the big banks like RBC (Royal Bank), TD (TD Canada Trust), Scotiabank (BNS), CIBC (Canadian Imperial Bank Of Commerce), BMO (Bank of Montreal), National Bank, etc. include a discount given in the IRD calculations.
When the mortgage is initially set up, most of the big banks will record the posted rate, the discounted rate and the amount of discount offered to the client. These lenders will then use these numbers in the future if the mortgage is paid out early.
For the rest of the calculations here, let me use the following mortgage closed, fixed rates that would be typical for the banks listed above:
- 3.59% 1-year discount rate (3.59% posted rate)
- 3.19% 2-year discount rate (3.74% posted rate)
- 2.89% 3-year discount rate (3.89% posted rate)
- 3.14% 4-year discount rate (3.94% posted rate)
- 2.97% 5-year discount rate (5.34% posted rate)
No matter when you read this, the thing to notice is the discount on various terms. This becomes very important when you pay out the mortgage early!
If over time, the interest rates rise, then the IRD penalty may not apply but that all depends on the posted rate and the original discount. Remember, the penalty is calculated as the greater of the IRD or 3 months interest penalty.
Let's calculate the mortgage penalty for a bank like RBC or TD or Scotiabank...
Let's assume that a client has a mortgage with a current balance of $350,000. Let's assume that the interest rates have not changed over the last 3 years. It's now 3 years later and the client has sold her home. She chose a 5-year term closed mortgage.
At the time she set up the mortgage, she chose a 5-year term. She received an interest rate of 2.97%. She received a discount of 2.37%. She was ecstatic when she set up that mortgage. The discount was excellent.
Now she has sold her home. To calculate the penalty, her bank will take the posted rate for the remaining term, namely 2-years and compare to her mortgage. The posted rate for a 2 year term is 3.74% (see above).
Her bank offered her a discount of 2.37%, therefore they will reduce the posted rate by the discount originally provided. To calculate this, subtract the discount of 2.37% from the posted rate of 3.74% to get a comparison rate of 1.37%.
The bank will then calculate the difference between the rate she has, 2.97% and the comparison rate of 1.37% to determine the interest rate differential. Her mortgage rate of 2.97% minus 1.37% results in a difference of 1.60%.
The bank will calculate the penalty by multiplying the difference by the mortgage balance and the remaining term. Therefore, the difference of 1.60% multiplied by the mortgage balance of $350,000 and there is 2 years left is calculated as $11,200.
The bank will compare a 3 months interest penalty as well and then charge the greater of the IRD or 3 months interest. For a mortgage of $350,000, three months' interest would be $2,598.75.
This client would be charged $11,200 to break the mortgage contract early.
Personally, I think this calculation is very unfair to the client! The lender is comparing a much lower rate than they can replace the mortgage at.
I do agree that a lender should receive compensation and earn enough profit to stay in business. Having a strong banking system is good for our country. I believe that a more fair calculation can be made to benefit both the consumer and the lender.
Let's look at the same client assuming she chose a 4-year term instead. If she sold her home after 3 years, and the mortgage balance was the same.
Her penalty would be calculated as follows: Original Posted rate (3.94%), mortgage rate (3.14%), discount (0.80%). After 3 years, there would be 1 year left, the posted rate is 3.59%, the discount of 0.8% would be subtracted to calculate the comparison rate of (3.59% minus 0.80%) 2.79%.
Her mortgage rate is 3.14%, minus the comparison rate of 2.79% works out to be an interest rate differential of 0.80%. Over 1 year, the interest cost for a mortgage of $350,000 at 0.80% would be $2,800. The 3 months interest penalty was calculated before at 2,598.75.
For this example, with a 4-year term that's paid off after 3 years, she would pay $2,800 to break the mortgage with 1 year remaining.
I have gone through a bunch of numbers here. I want to compare this calculation to calculations that are done by Monoline Lenders.
IRD Mortgage Penalty Calculations for Monoline Lenders
A monoline lender is a lender that only deals in mortgages. Many of the monoline lenders will calculate the IRD differently than the big banks do. Lenders like First National, Merix, MCAP, RMG, Lendwise, etc. all calculate the penalty based on the posted rate and don't use the original discount.
For the rest of the calculations here, let me use the following fixed closed mortgage rates for a monoline lender that are taken at the same time as the rates show for a bank, previously listed above:
- 3.99% 1-year discount rate (3.99% posted rate)
- 3.34% 2-year discount rate (3.34% posted rate)
- 3.34% 3-year discount rate (3.34% posted rate)
- 3.34% 4-year discount rate (3.34% posted rate)
- 2.79% 5-year discount rate (3.09% posted rate)
First off, there are a couple of differences. The banks are offering lower rates on shorter terms. The monolines are showing posted rates much closer to the discounted rates, if not exactly the same as the discounted rate.
To calculate a penalty for a lender like Merix, First National, MCAP, etc, let's use the same client example above. The client has a mortgage of $350,000. She has held the mortgage for 3 years. She chose a 5-year term originally and received an interest rate of 2.79%. The mortgage rates have remained the same over the last 3 years.
She sold her home and will pay a penalty to pay off the mortgage. The 3-month interest penalty would be calculated as follows: her mortgage balance of $350,000 multiplied by her interest rate of 2.79% divided by 12 and multiplied by 3 which results in $2,441.25.
To calculate the IRD penalty, these lenders compare the posted rate to determine the difference. The client's mortgage rate is 2.79%, there are 2 years remaining in her term, therefore the replacement mortgage rate is 3.34%. This rate is higher than her mortgage rate, therefore she will not pay IRD. The client only pays 3-months interest.
In this case, after 3 years, our example client would pay a total of $2,441 to break her mortgage early.
How can you avoid the penalty?
If you pay off your mortgage early and pay a penalty, then you can potentially get your penalty back.
The way to do this is to PORT the mortgage. Most of the lender will you to PORT the mortgage from your current home to a new home. If you do this within a certain period of time (some allow 30 days, others up to 4 months), then you get your penalty back.
When you PORT your mortgage, you essentially take the balance outstanding and the remaining term and move it over to your new home. If you need more money, then the lender will blend the rate you have with today's rates. This blended calculation is different for each lender. That could be the topic of another article!
The main point here is that you could potentially receive the penalty back, provided you purchase another home in a reasonable period of time.
When you PORT, some lenders will only blend with the remaining term. That is, if you have 1 year left, you can only choose a 1-year term for the new money you need.
Some lenders will allow you to blend the current mortgage amount and rate and term with a longer-term. This more complicated calculation essentially blends all the different factors into a new mortgage with one rate and payment.
Yet other lenders may allow you to have different mortgage sections. One section would be for the remaining mortgage and another section could be for the new money at a different term. With this type of set up, you may have 2 mortgage payments instead of 1.
All of these could help you to get that big penalty back.
Can I reduce the penalty?
It is possible to reduce the penalty in some cases. Most lenders in Canada will allow pre-payment privileges. Lenders used to allow clients to make the pre-payment privilege at the time of the mortgage payout.
That is, if you are allowed to apply a lump sum of $30,000 toward your mortgage each year. Let's say your mortgage is $200,000. You could pay $30,000 toward the allowable lump sum, then the balance is $170,000. The penalty would be applied to the $170,000 instead of the full $200,000.
Again, some lenders will allow this and others will not.
If you have extra money available. Most lender will allow you to apply a lump sum payment 30 days prior to your mortgage payout. If you apply this lump sum, then the penalty is calculated based on the lower mortgage amount. You will then, effectively, get your money back after 30 days.
All the lenders in Canada will charge a penalty to pay out the mortgage early. They not only have a contract with you but they have a contract with an investor.
All lenders will describe the penalty as the greater of 3 months interest or Interest Rate Differential (IRD) however the calculations aren't all the same!
Make sure you review your numbers and know what you are signing. The lowest interest rate may not always be the most beneficial, especially if you pay out the mortgage early and don't replace it within 4 months.
It's always a good idea to review your options with a mortgage broker who can highlight the differences and offer you choices and options.