A mortgage is a contract between you and the lender. The contract has terms, conditions, obligations, rights and so on. Many lenders will allow you to break the contract 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). Learn more here about what an interest rate differential is and how different lenders calculate it.
Interest Rate Differential
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.
When calculating an interest rate differential, the calculation can be more lender focused with a larger penalty, or more client focused with a smaller penalty.
Learn more: The most common reasons people break a mortgage
How is IRD calculated?
Let’s look at a few ways lenders calculate an interest rate differential.
Posted rate calculation:
This is a more lender focused calculation and is generally used with banks and some credit unions. For this calculation think big bank, big penalty.
Also, this calculation typically uses the Bank of Canada posted rate.
Here is an example:
Two years ago you got a 5 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. For this calculation think smaller lender, smaller penalty.
Learn more: Monoline lenders
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 interest rate differential 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.