Understanding Prepayment Penalties
When buying and refinancing, it’s easy to overlook prepayment penalties during the information overload of a home purchase. Most people assume they will live in their home forever and don’t plan to “break up” with their mortgage lender. But statistics have shown…
6 out of 10 Canadians will break their current mortgage at an average of 38 months
Common reasons for triggering a penalty are health issues, marriage, divorce, and employment transfers, promotions, or layoffs. If you have the potential to be transferred to a different part of the country for work, be sure your mortgage is placed with a national lender to possibly avoid a penalty.
You can also be penalized for leveraging dormant equity from the property to start a business, consolidate debt, grow current business, or raise funds to help a family member’s purchase. This list of unforeseen events can go on and on, because for many of us, life happens.
What should you look for in penalty calculations?
Even though you might save money over time with a fraction of a percent lower rate, choosing a product and a lender with better prepayment penalties might save you $10,000 or more, when life happens.
Whether you even have to pay a penalty depends on if your mortgage type is closed or open. These names sound exactly like what they are. Closed mortgages are closed to prepayment and are subject to a penalty if paid back prior to the completion of the term. Open mortgages are open to prepayment and not subject to a prepayment penalty. You might think open is the obvious choice, but the interest rates are much better on closed mortgages.
Two Kinds of Penalties
You’ve probably heard of the 3 months’ interest penalty. This is the most common penalty. As an example, a $400,000 mortgage at 3% is $12,000 a year, or $1,000 a month. The prepayment penalty would be $3000. This might seem like a fixed, reliable figure, but you should keep in mind that some banks calculate the rate at the prime rate and some calculate at net rate (your rate discount based on prime). Calculating the penalty on the net rate or even the prime rate is more favorable, and that’s what I will recommend to my average client. The second way to calculate the penalty on a fixed rate closed mortgage term is a little less known.
In my 10 years in the mortgage business, I’ve seen some high prepayment penalties based on Interest Rate Differential. This penalty, sometimes called an IRD, was around $15,000 penalty for a balance that was just under $100,000. IRD’s might not always be so terrible, but it’s the kind of situation that you hear horror stories about. Major banks’ penalty calculations for fixed rate products are not as easily calculated as the 3 months’ interest penalty, and not as easily understood as non-bank lenders’ calculations. Big banks use the posted rates to give themselves a larger profit, which is usually coming out of your wallet.
How IRDs Work
Here is a hypothetical situation. Your current mortgage is $400,000 at 2.89%, for 5 years fixed. You keep the mortgage for 2 years, but then life happens. You break the term with 3 years left. A non-bank lender’s current 3 year rate might be 2.64% so your penalty would be 0.25% on the $400,000 over the 3 remaining years. This would approximately be $3000.
Here’s the same hypothetical mortgage, except you chose to borrow from a big bank. You have the same $400,000 mortgage at 2.89% fixed rate, for a 5 year term. The posted rate is 5.09%, and there was a -2.20% discount. The bank decides to use the posted 3 year rate of 4.10%, because the bank can use your situation to recuperate their loss and then take a little more while they’re at it. If the discount on the 3 year given is still 2.20%, the rate would be 1.90%, resulting in a difference of 0.99%. That’s a lot, compared to the non-bank lender’s difference of 0.25%. Your approximate penalty based on the major bank’s calculation would be $11,880.
(Please note: the numbers used above are approximate, an example, and not based on today’s market.)
How do you avoid a big penalty?
I recommend picking a short-term fixed rate or a variable rate product, generally speaking. If these are not options available to you, you should take a long-term fixed rate product but avoid borrowing from a big bank. Using a mortgage broker who will go over all the lender options and educate you on differences is always a good tool. This way, you’ll be aware of the differences and know what prepayment penalty you’ll be getting yourself into. Remember, just like in grade school, there are no dumb questions. Ask away! As always, be sure to go over your options before signing a contract.
If you have any questions about all of this or what it means for you and your situation, feel free to contact me.