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Talking about mortgage penalties…
When playing sports, we sometimes don’t follow the directions or rules. When we don’t follow the rules in a sports game, we are given a penalty. In sailing for instance, if a sailor hits a mark during a race, they are required to do a “spin” to clear themselves and then they continue racing. If they don’t do the circle, they risk the chance of getting thrown out from the race and a large sum of points gets added to their score. A penalty in once race can end up costing them the whole regatta if they accumulated too many points. In the mortgage industry, there are a few “rules” that borrowers have to follow and if they break it, they may face mortgage penalties.
In a mortgage contract, you and the lender agree on how much you are allowed to pay off and when. Typically, lenders allow borrowers to pay off 15 per cent of the mortgage balance each year without penalty. Borrowers that have broken their contract by paying off their mortgage too early are subject to prepayment penalties. Additionally, borrowers that transfer their mortgage to another lender before the end of their term are subject to prepayment penalties.
How much will it cost me?
Prepayment penalty costs will vary depending on the lender and the contract you agreed upon. Usually, a prepayment penalty is equal to 3 months’ interest on the amount the borrower still owes, or the interest rate differential. The IRD is the difference between the interest rate of the current mortgage and today’s interest rate for a term that is the same length as the remainder of the current mortgage. The prepayment penalty for variable-rate mortgages is always 3 months’ interest.
So, let’s say we have an outstanding balance on our mortgage of 300,000 at a rate of 2.99 per cent. We have 36 months left on our 5-year term and are looking to break our contract. The current posted interest rate for a 36-month mortgage term offered by our lender is 2.95%. When we multiply our outstanding balance by our current interest rate, we get $8,970. We divide that amount by 12 months to get the monthly interest payment of $747.50. When we multiply that by 3 months, we get an estimated prepayment penalty of $2,242.50.
Taking the rate and outstanding balance we used for calculating it for the 3-months of interest, we’ll calculate it using the IRD. To calculate the prepayment penalty using the IRD, we need to know the current posted interest rate. The current posted interest rate for a 36-month mortgage term offered by our lender is 2.95 per cent. When finding the difference between our annual interest rate and the current interest rate offered, we get a difference of 0.04 per cent. Multiplying the difference by the outstanding balance we get $120. Dividing that by 12 we get $10, which we then multiply by 3 to get $30 for out estimated prepayment penalty based on the IRD.
Usually, when lenders calculate the prepayment penalty towards a borrower, they will choose the higher of the two. In the example we used, there was a significant difference in the amount a borrower would have to pay. This can make a dent in a borrower’s wallet if they don’t review their contract correctly to see how their lender will penalize them. For borrowers that are concerned about how a prepayment penalty could affect them, give us a call at Clinton Wilkins Mortgage Team. You can get in touch with us here.