When it comes to mortgages, it is easy to focus on the rates and your current situation, but the reality is that life happens and when it does, rates won’t be the only thing that matter. Trust me. In my experience doing mortgages, the one constant that I can tell you is that “life happens” and mortgage penalties are often a very serious concern when it does.
At the end of the day, a mortgage is a contract between you (the homeowner) and the bank / lender. As such, there are often penalties involved if the contract is ever broken. This is something that every homeowner agrees to when the mortgage paperwork is signed, but it can be easy to forget – until you’re paying the price. These things do happen – approximately 6 out of 10 mortgages in Canada are broken within 3 years. 60% is a pretty high likelihood and even the most well-organized, meticulous planners have seen life happen.
Should your circumstances change, knowing the next steps can help you navigate the process.
Calculating Penalties on Closed Mortgages:
Typically, the penalty for breaking a closed mortgage is calculated in two different ways. Lenders generally use an Interest Rate Differential calculation or the sum of three months interest to determine the penalty charged. Borrowers are typically be assessed the greater of the two penalties, unless your contract states otherwise.
Interest Rate Differential (IRD) aka the Nasty One! (Typically specific to fixed-rate mortgages).
In Canada, there is no one-size-fits-all rule for how an IRD penalty is calculated and it can vary greatly from lender to lender. This is due to the various comparison rates that are used. Typically, the IRD is based on the amount remaining on the loan and the difference between the original mortgage interest rate you signed (posted rate) at and the current interest rate a lender can charge today.
Ideally, you will want to be aware of what your IRD penalty would be before you decide to break your mortgage as it is not always the most viable option and this penalty can be substantial.
In this case, these penalties vary greatly as they are based on the borrower’s specific mortgage and the specific rates on the agreement, and those available in the market today. That means that it is a very complicated calculation. I have seen this penalty in the tens of thousands and it’s not too rare to see that. I have blogged previously on the true cost of a mortgage contract.
Chartered bank fixed-rate mortgages sound like the safest bet for your mortgage right?? Think again. These ones tend to have some of the highest penalties of all. This is why, when choosing a mortgage, that you trust an expert that can look at multiple lender options for your specific case.
Three Months Interest:
In some cases, the penalty for breaking your mortgage is simply equivalent to three months of interest. Using a simple example – $200,000 mortgage balance at interest rate of 3% – three months interest would be $1,500 penalty.
($200,000 x 3% / 12 months X 3 months).
A variable / adjustable rate mortgage is typically accompanied by only the three-month interest penalty and this almost always is the lowest possible penalty that you can pay on a closed term mortgage. This is a major consideration and why an adjustable / variable mortgage provides the best possible flexibility from “life happens” moments.
Paying The Penalty
When it comes to paying a penalty, some lenders may allow the penalty to be added to your new mortgage. You can also pay your penalty by having the cost added to the mortgage upon early payout. If you can wait out your current term before making a change to your mortgage, it is the best way to avoid being stuck in the penalty box. If you cannot wait, do note that, while calculators can be ok tools for estimates, it is best to contact me directly to discuss your mortgage specifics and potential penalty calculations / steps. You want to have an accurate number in mind so the potential penalty doesn’t come as a surprise and leave you short or scrambling for cash at the lawyer office.