Not all mortgage prepayment penalties are the same

The story of prepayment penalties

This is a story about Joe and Sue. Two different people with similar mortgages, but very different prepayment penalties.

Joe and Sue each buy a house at the exact same time for the exact same price and get a mortgage for the exact same amount. The only difference is Joe uses a Big Bank, and Sue uses a monoline lender for their mortgages. Let’s assume they both received a rate of 2.99 per cent for a five-year fixed term.

Three years later

Three years into their mortgages, Joe and Sue are both going to be paying off their respective mortgages which are both at $250,000 at the time of the payoff. Now to keep the comparison fair, we will pretend that interest rates have not changed at all for any of the terms, whether it is the posted rates or the discounted rates. The rates are based on the actual interest rates at the time of writing.

Now because they have ended their five-year contract early, they will have to pay a penalty. Both agreed at the time they took out their mortgage they would pay the greater of three months’ interest or the Interest Rate Differential (IRD). The IRD is in place so that the lender will be reimbursed for any income they would lose because you broke the contract early. In theory, it should only apply when rates have gone down from the rate you agreed to pay. In this example, they each agreed to pay 2.99 per cent for five years, so if rates had dropped to 1.99 per cent, the lenders would be entitled to the one per cent difference for the remaining two years. Which is fair.

If you invest $1000 and are told at maturity your investment would be worth $1200, you would not want to get $50 and be told, “sorry, someone else changed their mind.” You, like everyone else, would want the full $200 you were promised. Same idea. Only the banks are using the IRD to punish you for leaving or to force you to stay with them. Which is not fair, nor is the idea behind an IRD.

In our example, Joe and Sue each have to pay prepayment penalties. But how much they have to pay is a shocking difference!

Sue’s monoline penalty: $1,868 

Joe’s Big Bank penalty: $8,750 

That’s a difference of $6,882 !!!

So why such a huge difference? In the simplest explanation, it’s the “discount” given by the big banks.

An explanation

Let me explain. With a monoline lender, as Sue used, that mortgage brokers usually use, they offer their best rates upfront. So they generally only have one rate for each term length, whereas the banks have two rates for each term. The posted rate, and the discounted, or special offer rate. Almost everyone actually pays the discounted rate, but the banks use the posted rates when calculating the Interest Rate Differential. That is how they come up with huge IRD penalties.

The math behind it can be a bit confusing when you read it, so pretend you’re back in high school math class…but pay attention this time.

So the banks take the rate you are paying (2.99 per cent in our example), subtract the difference between what is the current posted rate for a similar term for the time remaining (two years at 3.04 per cent) less the DISCOUNT GIVEN. The posted rate in our example is 4.79 per cent minus the real rate of 2.99 per cent, which is a discount of 1.80 per cent. That is what is going to cause the pain. So they take the similar posted term rate then minus the discount (3.04 per cent – 1.80 per cent). Then they multiply that number by the balance owing and the time remaining.

Big Bank IRD calculation:

2.99 per cent – (3.04 per cent – 1.80 per cent x $250,000 x 2 years = $8,750

Compared to a true IRD calculation:

(2.99 per cent rate – 2.79 per cent comparable rate for term remaining) x $250,000 x 2 years = $1,000 which is less than the three months’ interest, $1,868, which is what Sue would be paying. The Interest Rate Differential should not have come into play.

The numbers

Let’s base the numbers we use on rates at the time of writing

To make up for such a monstrous penalty from his bank, Joe would have needed a rate of 1/2 of a percent (0.5 per cent or 0.005) which is 2.49 per cent lower than the best rate at the time from the banks. There is more to consider with a mortgage than just rates. Know your other risks.

At the time of writing, the penalties according to the Big 5 Banks’ online calculators and their listed posted rates are:

BMO: $8750, Scotia $8250, RBC $9057.85, and CIBC $10,677.65. TD Canada Trust’s online calculator not working but it would be $8750. The banks’ penalties differ somewhat mainly because of differences in the banks posted rates.

This post is put together by our friends at corporate!  Thank you to CENTUM for this great info!  If you want more info on prepayment penalties or anything else, feel free to contact us!