A number of people in Canada end up paying big mortgage penalties, and the fact that an increasing number of people are asking how they can avoid big mortgage penalties comes as no surprise. An easy way to move forward is to compare the penalty formula for big five banks vs. Monoline lenders.
Let’s choose a real life example, but remember that these calculations are estimate numbers and penalties may vary from lender to lender.
Tom’s Story
As a first time buyer Tom was very excited about the fabulous big bank employee pricing mortgage, tied to a five year fixed rate that offered a 2% discount. Since the bank’s posted rate was 4.64%, a 2.64% mortgage rate made Tom very happy, initially. The bank, however, failed to mention the penalties involved in breaking a fixed rate mortgage, which can come about by simply selling his first home.
Taking into account that the average life of a mortgage in Canada is three years, Tom’s story is very common. Tom learnt the hard way that the penalty to get out of a five year fixed rate mortgage is significantly larger than the simple three months penalty that his bank rep told him that he would most likely pay.
Now, Tom wants to know how to calculate the penalty. Big bank answer, anytime you break your mortgage with a lender that is a fixed rate, you will be subject to either a three month interest penalty or IRD, whichever is higher.
What is IRD or Interest Rate Differential?
Simply put, it is the difference between your contract rate and the rate of the term you left over at the time of discharge in your mortgage. In Tom’s case with the big bank, he had to pay the interest differential.
Here are details Tom wishes he knew at the beginning of his story:
On $450,000, with 2% discount on the posted rate, his balance is $ 410,238.67. Since Tom has two years left in his term, the bank will calculate the rate of return on the current posted two year rate of 2.84%. The bank will take the 2% discount which previously made Tom happy off the posted rate off the posted rate of 2.84% to equal 0.84%, and subtract that from his contract rate of 2.64%, to equal 1.8%.
This is how the big bank will calculate the penalty – $410,238.67 x 1.8% x 2 years remaining in the term to equal $14,768.59.That’s a big penalty.
The big bank will also give Tom options of blending or extending the mortgage. However, the rate will get blended with the penalty, which is another hidden cost.
An alternative happy ending
If Tom spoke with a mortgage broker and used a Monoline lender his penalty would have only been $3,283.84. That’s a savings of over $11,000. Tom would have originally received a 2.69% mortgage rate. His outstanding balance after three years would be slightly higher at $410,480.52. The best rate at the monoline lender would be2.29%. The penalty would also be either three months or IRD, which is 2.69% minus 2.29% to equal 0.4%. This times 410,480.52 equals $1641.92. This multiplied by two equals $3,283.84, which is a considerably lower penalty when compared to the big bank’s penalty.
What this example clearly demonstrates is that it pays to know all the facts the banks don’t tell you, and avoiding big mortgage penalties is not impossible if you know which mortgage to get in the first place.
If you are lookig for a mortage broker in Brampton, please contact me so I can help you avoid big mortage penalties.
