Mortgage Penalties - What do you need to know before signing on to a mortgage???
Posted on Jul 25, 2012 in Mortgage Market Updates and News
We've all heard the horror story of a friend or family member who paid out their fixed rate mortgage early and was stuck with a $20,000+ penalty. Horrible! But is this something you could be stuck with it you needed to pay out your mortgage early? What do you need to know before signing your mortgage agreement to avoid this huge penalty? Are lenders all lenders equal when it comes to penalties, or are some more flexible?
Well, there's definitely a lot to know when it comes to these penalties. The best thing you can do to protect yourself is to ask questions and do a bit of research.
There are two types of mortgage penalties you can be charged upon paying out your mortgage early, a 3 month interest penalty, or an Interest Rate Differential Penalty. Interest rate differential is the difference between what you would pay if you stuck with your current mortgage, vs what you would pay signing onto a new mortgage, calculated based on the amount of time left on your term. So essentially, the larger the split between the mortgage rate you're currently paying, and rates available now, the larger your penalty. In times like these, when rates are very low, any people are trying to get out of their mortgages, with 5+% rates, and take advantage of the great rates offered now. But there's now a spread of about 2% between what these people were paying, and what they'd be paying now, so the penalties are large. That being said, for people signing onto mortgage now, it's likely that if they need to pay out their mortgages early, rates will be higher. So they'll run into a reverse split, where the rate you are currently paying on is LOWER than what you would get signing a new mortgage, in that situation, you'll likely end up paying a small 3 month interest penalty.
The first thing you need to know and about IRD calculations is that unfortunately, in Canada, the mortgage penalty calculation (interest rate differential), is not standardized, so every lender has the right to set their calculation however they like, so long as they lay it out in their standard mortgage terms (which most people never even look at). Some countries have started to move toward standardized calculations so it's clear, as the average consumer really understand the difference between the techniques for calculations, or doesn't even think to ask about penalties before signing their mortgage.
One way to avoid the huge penalty is a variable rate mortgage. Most variable rates don't use IRD calculations, but rather charge a 3 month interest penalty, which is typically substantially lower. That being said, I'd like to reinforce that right now, with fixed rates so low, it's likely if you pay out a 3% fixed rate mortgage early, you'll also have a 3 month interest penalty, not an IRD.
Most banks have prepayment calculators on their websites, take advantage of these, put in your potential mortgage details and say you were to pay it out two years into your term, see what your penalty would be.
In terms of flexibility with penalties, if you're signing onto a new mortgage with that lender, you will often be able to negotiate a lower penalty. If you're just closing your mortgage, you're unlikely to get any flexibility. But, are some lenders penalties lower than others...?
YES! This is very important, if you take away one thing from this blog post let it be this, lenders who have high posted rates (you can look at their rates section on their website, and if their posted rate is more than a 1% higher than the rate they're giving you, it's high), have higher penalties. The reason for this is that when you pay out a mortgage for a lender with a posted rate, they charge you a penalty prorated for the rate they 'could have' charged you with that posted rate. Not all lenders have posted rates that are higher than regular or discounted rates. Do your research, check it out before signing.
Please visit http://www.canadianmortgagetrends.com/canadian_mortgage_trends/interest-rate-differential-ird.html (this is just an estimate and should not be used for actual mortgage pay out calculations). Notice with the numbers that come in the calculator the IRD penalty would be 11,000. Now delete the 1.5% discount off posted rate and see what happens. It drops to 5K!!! That's a huge difference. So it's important to consider the difference posted rates can play in your potential mortgage penalty.
Call Sharie Marie Francoeur, Mortgage Professional with TMG The Mortgage Group Canada, to discuss your options.