One of the questions I get asked about most often has to do with mortgage penalties. What are they? Why am I being charged one? Can I avoid it, and how did this figure get calculated?! These are just a few of the hot-button topics I am looking to discuss in this blog.
So, why are there mortgage penalties in the first place? Any time you break your mortgage term early, your lender is missing out on the interest that they would have been earning from your mortgage had it remained with their institution for the full length of your term. Due to this loss, lenders will attach a penalty to compensate themselves, as well as to discourage their clients from going elsewhere.
Depending on your mortgage type, the way your penalty is calculated can vary. I have found that most people don’t fully understand how their penalties will be calculated. To know this, though, you must first know what type of mortgage you have- fixed, or variable. One big misconception is that you’ll only be charged a 3-month interest penalty if breaking your term. This may be true of most variable-rate mortgages, but for fixed-rate terms, there is another factor to consider. For fixed-rate mortgages, there is another form of potential mortgage penalty, called interest rate differential, or IRD.
For a fixed rate mortgage, the penalty you are charged is either 3-months’ interest on the outstanding balance OR the IRD, whichever of the two is GREATER. 3-months’ interest is relatively easy to calculate, but IRD takes a few different things into consideration. Things to consider are how much time is left on the mortgage, what is the size of the mortgage remaining, what rate discount did you receive at the time of initial mortgage funding, and what are current market rates in comparison. Each financial institution will likely calculate its IRD slightly differently from one another, so it’s important to use their individual calculator tools.
Things like cash back at closing, and whether an institution bases their loss on current interest rates or those offered at the time of initial mortgage funding can also have an impact here, so it’s not always as simple as 3-months’ interest. For example, I went on to two different bank IRD calculators and entered the same basic mortgage information. One calculator gave me a penalty figure of $9,250, and the other was $13,500. If you are watching your dollars closely, this could mean a shortfall in new funds, closing costs, or an inability to close a new deal. It’s always best to get your penalty upfront to avoid surprises and preferably in writing.
So, is it possible to avoid a penalty altogether? The answer is “yes,” you can go into an open mortgage which allows you to prepay your mortgage at any time without a penalty. The downside to an open mortgage, though, is that it comes with a higher interest rate than its fixed or variable counterparts, so I would only suggest an open mortgage to those who intended to carry the mortgage for a very short period of time.
My best advice to keep your penalty at a minimum would be to speak with a mortgage professional and discuss your situation in full, in an effort to help put you into the appropriate product type moving forward. If future penalties are a concern to you, there are mortgage products that have minimal mortgage calculations overall if you know that the home will no longer be in your possession in a few years. Some things to consider when discussing mortgage products are: how long do you plan to keep the property? Do you have plans for a refinance in the near future, and what is your risk tolerance? Knowing this information will help your mortgage professional best help you achieve your goals, and provide you with a mortgage that best fits your financial landscape. A mortgage is one of the biggest liabilities an average individual may carry in their lifetime, so making sure the product as a whole fits your financial future rather than just looking at a low rate is important.
I know there has been a lot of confusion about this topic, so I hope that this blog has helped to clear the air of any questions you may have had about penalties. If you have any other questions, call me at 519-250-4848, send me an email at Rasha@ShopMortgages.ca , or fill out the form below.