If you’re thinking about selling your home, you’re not alone. Canadians traded record numbers of homes in September.
Sales were up a mind-boggling 56 per cent in Vancouver compared to the same month last year. In Toronto, they surged by 42 per cent.
But even outside the usual real estate hot spots, the market was in a frenzy of activity, despite the looming threat of a second wave of COVID-19 cases. Nationally, sales are up by more than 30 per cent, a recent CIBC report noted.
But if the pandemic has tickled your appetite for a bigger home or a gateway far away from the city and its mask-wearing crowd, take a moment to review your current mortgage, several mortgage brokers warn.
Breaking your mortgage could cost you up to tens of thousands of dollars these days. In fact, mortgage broker Robert McLister says he’s seen penalties on fixed-rate mortgages as high as $99,000.
Penalties are meant to compensate lenders, says McLister, who is mortgage editor at Rates.ca and founder of mortgage rate comparison site RateSpy.com. After all, when you get out of your mortgage early, you’re breaking your contract.
But a number of factors influence just how much of a penalty you’ll end up paying.
Your mortgage type affects your penalty
With a floating rate mortgage, the penalty is usually straight forward. In most cases, your lender will charge you three months’ worth of interest.
Some no-frills mortgages with very low interest rates, however, may charge bigger penalties, sometimes up to three per cent of the principal or six months of interest, McLister says.
These mortgages “are popular products given how fixated people are on the lowest rate. But the higher penalties sometimes end up costing people far more than the upfront interest savings,” McLister warns.
In general, though, it’s five-year fixed-rate mortgages that can really get Canadians into trouble when it comes to penalties.
With a fixed-rate loan, your fee is generally the greater of either three months’ interest or a formula called the interest rate differential, or IRD. This is meant to compensate the lender if they can’t re-lend the money you paid back early at a rate as high as you used to pay.
In its simplest form, the IRD is calculated by taking the difference between your contractual rate and the lender’s current rate that most closely matches the time remaining on your mortgage term, according to mortgage broker David Larock.
For example, Larock wrote in a recent blog post, let’s say you have a mortgage balance of $250,000 with a fixed rate of 2.59 per cent and two years to go on your five-year term. Let’s also say your lender is currently charging 2.29 per cent on two-year fixed-rate mortgages.
The lender will calculate the difference between the rate it was charging on your five-year loan and what it can charge on a two-year loan and multiply that by your mortgage balance and the time remaining on your term (expressed as the number of months remaining on your mortgage divided by twelve).
Here’s the formula used by Larock:
(2.59% – 2.29%) * $250,000 * (24/12) = 0.30% * $250,00*2 = $1,500.
In this case, though, the lender would be better off charging you three months of interest, Larock notes, so that’s what you’d end up paying. The formula is:
2.59% * $250,000 * (3/12) = $1,619.
Penalties for fixed-rate mortgages come in many varieties
Online bank Tangerine is one example of a lender using the simple IRD formula illustrated by Larock.
However, “a lot of lenders charge bigger penalties than are required to make them whole,” McLister warns. The key question to ask a lender, he says, is whether their penalty is based on the actual mortgage rates they charge customers — also known as discounted rates — or on higher posted rates that few borrowers pay.
In one version of the IRD formula used by many of the big banks, the lender takes your contract rate and subtracts from it the difference between the posted rate that most closely matches your remaining term and the original discount you received off of their five-year posted rate, writes Larock.
Assuming the discount on your contractual rate five-year mortgage rate was 2.05 per cent, and the bank’s posted rate on two-year mortgages was 2.84 per cent, the difference between the two would work out to a tiny 0.79 per cent.
The lender would then take the difference between your rate of 2.59 per cent and 0.79 per cent, yielding 1.8 per cent. That’s much higher than the 0.30 per cent of the simple IRD calculation and it results in a much larger penalty.
The formula is:
(2.59% – (2.84% – 2.05%) * $250,000 * (24/12) = 1.8% * $250,000 * (24/12) = $9,000
The lender is taking the steep discount they gave you off of their five-year posted rate and applying it to its posted rate for two-year mortgages, Larock notes.
“This tweak makes a big difference to the cost of your penalty and is blatantly one-sided because lenders don’t discount shorter-term fixed-rate mortgages nearly as deeply as they do their five-year terms,” he writes.
There’s another way of calculating the IRD, by subtracting the posted rate that most closely matched the time remaining on your term from the lender’s five-year posted rate offered at the time you took out the mortgage. This can result in an even larger penalty, Larock writes.
You may want to turn to a so-called “fair penalty” lender, which charges fees that reasonably compensate it for you breaking your loan contract without charging punitive amounts.
A number of online banks and alternative lenders use fair penalties, according to Ratespy.com.
How much is left on your term?
Your penalty depends, in part, on the size of your mortgage balance. It would seem obvious that the further along you are in paying down your mortgage, the smaller your penalty will be. But that’s not always how the math works.
How far along you are in your mortgage term affects which comparison rate your lender will pick for the IRD calculation.
“It make may sense to rush a refinance or delay a refinance, for example, in order to get a more favourable comparison rate,” McLister notes.
Have interest rates been rising or falling?
Whether interest rates have been rising or falling since you took out your mortgage also matters.
Many Canadians these days have been blindsided by exorbitant penalties because today’s low interest rates mean the difference between people’s pre-pandemic mortgage rates and comparison rates has widened, resulting in bigger penalties.
Still, if you’re facing a big penalty, you may be able to reduce it by taking advantage of your prepayment privileges, which allow you to pay a portion of the mortgage early cost-free. This will help you lower the balance used to calculate your penalty, McLister notes.