Breaking your low rate mortgage might cost more than you’re saving

Breaking your low rate mortgage might cost more than you’re saving

So life happens, a marriage splits, your partner gets downsized or transferred to another city. Or perhaps interest rates have dropped and you’d like to lock into new rates, or a fantastic investment opportunity comes along.

There’s countless reasons you might want or need to change (break) your mortgage early. However most people are surprised when their bank or lawyer tells them how much their penalty will be; not all lenders calculate the penalty the same. Let’s look at the two most common ways:

Normally, a lender will use an Interest Rate Differential (IRD) penalty or a 3-month interest penalty. The penalty that comes with the breaking of a fixed-rate mortgage will often be whatever is more – IRD or 3-months of interest. There are some cases when the mortgage is close to maturity and the 3-month interest penalty will be much higher, but normally the IRD penalty is higher. 

A variable rate mortgage will often only use the 3-month interest penalty. Although, there are some variable mortgages that will offer a lower rate, but also use an IRD. There are also times when they are closed, and you are not allowed to break them unless you have a final sale on the property. This can also be the case for niche fixed-rate mortgages. 

The IRD penalty may have large differences based on the lender. 

The IRD penalty will be based on 3 different things: 

1. The principal balance at the time that it is broken.
2. The difference between the original mortgage and that of the interest rate charged by the lender for the term closest to what remains on the mortgage. For example, if there are only 21 months left, then the lender will normally use a 2-year term interest rate to be the comparison rate. 
3. The time that remains on the mortgage term. 
4. The discounted interest rate (what you pay) and their posted interest rate (what your penalty will be calculated on)

If the lender is using a discount on the posted rate, it can make the difference within the comparison rates. This can increase the IRD penalty. 

For instance, look at these 2 examples for a 5-year fixed mortgage: 

• Mortgage Amount: $300,000
• Current Interest Rate: 2.69%
• Discount on Posted Rate: 1.95%
• Months left on Mortgage: 22
• Comparison Rate from Lender: 3.04%

If one lender uses the posted rate to calculate the IRD, then there will be a differential of 1.6%, and the penalty would be $8,800. 

For comparison, another lender who only uses effective or contract rates to calculate the IRD. This means that no discount is able to be used, and the comparison rate for a 2-year term would be 2.19% with a differential of 0.5% and the penalty would be $2,750. 

In each of those examples, the 3-month interest penalty would be $2,018. 

Whenever mortgage shopping, it is best to look at the interest rate but also at: 

• If the interest is calculated each month or semi-annually, which means that it can be up to only a few hundred dollars each year if you happen to pay extra. 
• The pre-payment privileges could be 25%, 20%, or 15%. 
• How the lender calculates the IRD penalty when a mortgage is broken. 
• If there are prepayment privileges or if it will be a closed mortgage, except for a bona fide sale. 

If the math above makes your brain hurt and you’re looking for help better understanding your options, reach out to your trusted mortgage broker to discuss solutions to minimize the costs to break.

Steve White is a licensed mortgage advisor with Mortgage Alliance, Canada’s largest mortgage brokerage. You can reach Steve with your mortgage and real estate related questions and mortgage approvals by email – Steve@SteveWhiteMortgages.ca or cell/text – 905.903.4799.