A mortgage is a contract between you and the lender. The contract has terms, conditions, obligations, rights and so on.
When you take a mortgage you are agreeing to follow the terms of the mortgage until the maturity date, or the expiry date, of the contract. Sometimes the unexpected can happen and one needs to break their mortgage contract prior to the expiry date.
Many lenders will allow you to break the contact if you pay a penalty. For a fixed rate mortgage, this penalty is often the higher of three months of interest or an Interest Rate Differential (IRD).
When calculating the IRD, the calculation can be more lender focused, a larger penalty, or more client focused, a lesser penalty.
Let’s look at a few ways that IRD is calculated.
Posted rate calculation: This is a more lender focused calculation and is generally used with banks and some credit unions. Think, big banks – big penalties.
This calculation typically uses the Bank of Canada posted rate.
Here is an example:
Two years ago you got a five year fixed rate mortgage. The Bank of Canada 5 year posted rate at this time was 4.49%.
You now need to break you mortgage and there are three years left.
The current posted rate for a three year term is 3.64%.
If you subtract the current three year posted rate from the original five year posted rate you get 0.85%
With three years left in the term, you would times 0.85% by three giving you 2.55%. Therefore the penalty is 2.55% of your mortgage balance.
On a $350,000 mortgage, this would be a penalty of $8925. This is a very large penalty.
Published rate calculation: This is a more client focused penalty calculation and uses published rates. This is generally used by monoline lenders and most credit unions. See my video called Banks and credit unions versus monoline lenders to learn more about these lenders. For this penalty think, smaller lender – smaller penalty.
Here is an example:
Your rate is 2.79% and the current published rate is 2.69%. You have three years left in your contract.
For this you subtract the published rate from your rate which in this case gives you 0.1% and times that by the three years left giving you 0.3%.
On a $350,000 mortgage this would be a penalty of $1050. Now if the IRD penalty is lower then 3 month of interest, some lenders may charge the higher of the two.
As you can see the penalty with a published rate calculation is much more favourable then the calculation with a posted rate calculation.