Posted by: Tony Lam
Confused? There are two different types of penalties that banks will use to calculate the costs of breaking your mortgage – three months interest or Interest Rate Differential(IRD).
If you’re like many Canadian homeowners, you’ve likely got some questions. You’ve caught wind of interest rates making the news, leaving you possibly envious of Canadians taking advantage of such historically low rates.
In January 2012, fixed interest rates made big headlines in the national media. With advertised mortgage rates edging lower and fixed-rates at historic lows, the grass might be looking greener on the other side. Not surprisingly, many Canadian homeowners are looking for advice as to when it is worth breaking and escaping their old mortgage.
UNDERSTAND YOUR PENALTY
In more typical markets, most homeowners could expect to pay a three-month penalty and draw up a new mortgage at a lower rate than what they’d been locked into before. However, most mortgage commitments come with a clause in the contract; typically your lender is allowed to charge the greater of three months’ interest or the interest rate differential (IRD), which is essentially the difference between your old rate and current rates for your remaining term. Since interest rates have fallen so much, the IRD is usually the larger penalty. Unfortunately, the IRD penalty is sometimes calculated differently by different banks & lenders – often times confusing Canadians and leaving them shocked at their penalty amount, like our client above.
The three month interest calculation is the outstanding balance of the mortgage multiplied by the existing rate and then divided by four.
The IRD is a bit more complicated with the balance of your mortgage multiplied by the difference between the rate you received and the rate you’d have available to you today, multiplied by the remaining term, which may be rounded up or down.
The actual number from your lender may be lower if they use a present value calculation. And since lenders can calculate IRD differently, you should always get the actual penalty from your lender.
DOES IT PAY TO BREAK YOUR MORTGAGE?
Typically there are a few rules-of-thumb you should follow when calculating whether it is worth it to you to break your mortgage:
If you pay the penalty up front, then you want to determine if the interest you are saving over the remaining term is greater than the cost of the penalty;
If you add the penalty to the new mortgage, then you want to make sure your mortgage principal is the same or less at the end of the remaining term;
If you can blend the penalty into the new mortgage rate and the blended rate is lower than your current rate, then you are typically better off;
If you are in a term longer than 5 years and you have passed the fifth year, the three month penalty applies and not the IRD, this is Canadian law.
The exact terms on your mortgage may dictate whether there is value in breaking your mortgage. It is often worth taking the time to contact a qualified mortgage agent in order to have an analysis done on your unique mortgage situation.