When people come into a large sum of money for whatever reason – such as an inheritance or an investment – usually their first inclination is to start paying off their debt. It’s a great idea, and although it would be wonderful to knock a chunk off your mortgage with a big payment, unfortunately, lenders base their business on interest, and they expect to earn a certain amount for a certain amount of funds provided. By making a large prepayment you are, in effect, reducing their total earnings, and so lenders have placed serious restrictions on their use.
Prepayment penalties are referred to as Interest Rate Differentials (IRDs), and most often apply to fixed, closed mortgages. The IRD takes effect if you pay off your mortgage prior to the amortization date or make a payment on the principal that exceeds your prepayment privileges.
Most variable mortgages either do not have prepayment penalties or operate using a standard three-month interest penalty. But if you are a variable mortgage holder it’s a very good idea to speak with your lender or broker before making a payment over your allotted amount. Some lenders will charge penalties for making a large payment before the end of your term (especially if there’s a chance rates will rise before your next), and if you’re planning to switch lenders some refuse to consider prepayments made 30 to 90 days before you request discharge.
Mortgage Prepayment Penalties By the Numbers
Figuring out the amount of the IRD you may face by making a prepayment is complicated, but their totals are essentially based on two factors:
- The amount you are pre-paying.
- A rate percentage based on the difference between the interest rate the lender can charge today when re-lending the funds you have paid off and the interest rate you originally borrowed at.
Many lenders use a Comparison Rate for the amount of time that is closest to your remaining term to figure out your penalty. For example, if you have 18 months left, your lender may use their posted rate for a two-year term to calculate the rate difference factor of your IRD. Some other lenders may round down to the next-lowest term, which can significantly increase your prepayment penalty.
Example IRD Penalty Based on Completely Paying Off a $300,000 Mortgage
Current Mortgage Balance & Payment: $300,000
Current Interest Rate: 5.00%
***Your Discount: 1.00%
Months Left on Your Term: 22
Lender’s Comparison Rate for Two Years: 3.5%
Interest Rate Differential Penalty=$15,000
3-Month Interest Penalty $3,750
***For those that received a discount as an incentive to sign with a certain lender, you may be required to pay back that amount as well.
Closed, fixed-rate mortgage prepayment penalties are either a 3-month interest penalty or the value of the IRD – whichever is higher. Normally this is the IRD, and their totals usually begin in the four-figure range. However, Calgary’s high-value properties mean that number can easily reach five figures for a very large payment.
Refinancing Your Mortgage
Mortgage prepayment penalties can actually make a large payment not worth your while. It may be wiser to make several small payments, or even to refinance altogether. An Accredited Mortgage Professional like Candice Light is able to not only assist you in making a good decision about your prepayment, but as a mortgage broker is also your best bet for a successful refinance. Mortgage brokers have relationships with several lenders, and are able to effectively sift through the myriads of offers until they construct the right mortgage for you.
Not a lot of fixed-rate mortgages last for very long. The average five-year mortgage is refinanced by three years in, but not all those are subject to penalties. Mortgage brokers can help figure out what fees you may face should you suddenly be able to make a large payment for each particular lender. These are questions you SHOULD ask. Brokers can take a look across the board to compare penalties for prepayments made at certain intervals of your mortgage, and the answers you get will also clarify the type of mortgage that is best for you.
More Penalties to Watch Out For
- When refinancing or buying a home, inquire about penalties for increasing your mortgage. This is a very viable and often-used option for renovations or emergency funds.
- Ask about moving day procedures. Incredibly, some lenders require that you close on both your old and new home on the same day.
- Definitely ask about refinancing. Some fixed mortgages will NEVER let you refinance or move to another company unless you sell your home.
Protection for You
Canada’s Interest Act currently prohibits IRD penalties on terms over five years, but only after five years has elapsed. This means you will have to have paid off ten years of your mortgage before you can completely escape the IRD. After five years lenders usually apply a maximum 3-month interest penalty for breaking a mortgage before maturity instead of an IRD, but not always.
In reality, each lender has its own formula for calculating penalties, and they can vary greatly. Recently, Canada’s Department of Finance asked banks agree to a voluntary Code of Conduct that requires them to clearly post and explain prepayment charge calculations and provide calculators so people can estimate their fees on their own. Canada’s largest banks each now provides an IRD calculator online:
- Bank of Montreal
- ING Direct
- Laurentian Bank
- National Bank of Canada
- Manulife Bank
- Royal Bank
- TD Canada Trust
And by March of 2014, the Financial Consumer Agency of Canada will demand banks provide yearly written updates about consumers’ penalties, written penalty statements upon request and complete prepayment penalty quotes by telephone.
If you have any further questions about prepayment penalties or any other aspect of your mortgage, please feel free to contact Mortgages By Candice in Calgary. We look forward to shining a light on your financial future!