What is my mortgage penalty?

Posted by Maury Lum on April 15th, 2009 | No Comments

What is my mortgage penalty?

With where interest rates are and have been for the past few months, there has been growing interest, no pun intended, around if people who are currently in a mortgage should pay their penalty, break their term, and try to get a lower fixed rate for their mortgage. Many people today are in a mortgage with a fixed interest rate in the low to upper five percent range; possibly even higher. From a historical perspective an interest rate in this range is very good and likely people were pleased, as they should have been, with their rate at the time they arranged their mortgage.

For a similar mortgage today, a rate in the low four percent range would not be unreasonable to expect. So, depending on the mortgage amount, interest rate, and amortization period, it is possible that with current rates it could translate into a difference/savings of a couple of hundred dollars a month in the mortgage payment (possibly more, possibly less).

What many people are learning though is that the penalty to get out of their mortgage, in addition to the other costs involved to get out of their mortgage may not offset the savings of getting a new mortgage at a lower rate. When fixed rates drop the penalty to get out of a mortgage is typically arrived at through a calculation referred to as an Interest Rate Differential (IRD) calculation. In your mortgage documentation you will likely have a line item that indicates you can get out of your mortgage before the end of the term by paying three months of interest or IRD, whichever is greater. IRD will usually be the greater when rates have decreased from when you originally obtained your mortgage. The three months of interest will typically be the greater when rates have risen. Every situation is unique however, so inquire for your specific situation.

To find out how much three months of interest is it is a relatively simple amount to approximate as you can roughly say it is three months worth of payments. This is because at the beginning of a mortgage most of the payment is going towards interest. Over time though this balance shifts and gradually more of each payment goes towards the principal.

IRD is a much more complicated calculation as although the fundamentals of its calculation are the same between banks, banks can use different reference numbers (i.e. interest rates) to arrive at the end amount (i.e. penalty). The penalty here is based on the lost profit for the bank from you getting out of your current mortgage at a higher interest rate and obtaining a new mortgage at a lower rate, therefore paying less in interest. Essentially the IRD calculation is designed to take into account the difference in interest rates and the remaining time left in your term. The challenge here is that banks can use different reference interest rates in their formula to determine the difference between your rate and the current “market” rate. As such it is best to consult with your current mortgage holder (i.e. bank) to find out your penalty at any given time or I can also do this on your behalf provided I have a signed consent form from you. Please keep in mind as rates change, up or down, so will your penalty. Therefore if you decide to pay the penalty to get into a new mortgage we need to act quickly to ensure your scenario does not change from what you are expecting.

Additional points:

You may be able to add the penalty into your new mortgage so you have little direct out-of-pocket expense to arrange the new mortgage
Your new mortgage payment may be lower even with the penalty incorporated in, easing monthly obligations
Other potential reasons for arranging a new mortgage mid-term include: Renovations, Consolidate debt, Vacation, Investment, Help with child’s tuition, Purchase rental or vacation property
Sell current home, purchase new home, and want mortgage structured differently than before
If the penalty amount is such that it does not make sense for you to get out of your current mortgage, but you would still like access to additional funds, there may be alternatives: Second mortgage, Secured or Unsecured line of credit, Secured Visa line of credit with rates in the 7.99% – 11.99% range