If you prepay the entire balance of your mortgage loan before the end of its term, there will be a penalty to do so (i.e. exiting your mortgage in year 3 of a 5-year term).
Here are reasons borrowers exit their mortgage term early:
1. They sell their home.
2. They refinance with another lender.
3. They pay off the balance with inheritance or personal savings.
In order for your lender to calculate your penalty, they must follow a formula. Some lenders use a more expensive formula than others, and as a result, it is always beneficial to sort out how the lender’s penalties get calculated BEFORE you sign a mortgage contract. Of course, this exercise is necessary for any borrower who wishes to save money over the long haul. This is precisely a case of “failing to plan, planning to fail."
Here’s an example of a clause from CIBC Mortgages showing how a mortgage penalty will get calculated should the borrower exit their contract early:
If you have a fixed rate closed mortgage, your prepayment charge will be the greater of the following:
Three months worth of interest is easy to calculate, and using your interest rate, you can determine, at any point during your mortgage term, what the penalty will be. What you won’t know, however; is what the Interest Rate Differential calculation will be and if that will be higher than the three months worth of interest.
(If you have a variable rate mortgage, the penalty will always be just 3 months worth of interest).
How do you calculate the “Interest Rate Differential?"
The Interest Rate Differential or “IRD“ (in mortgage lingo) is based on the total amount you are prepaying. Here, the entire balance is being paid off.
The Penalty will equal the mortgage balance x Differential amount x the total months remaining DIVIDED by 12 months.
So, for example,
$100,000 mortgage with an interest rate of 9% with 24 months remaining.
The lenders’ current rate is only 6.5%
The differential is 2.5% (9-6.5%)
The issue with posted rates is they are not all the same and the higher the posted rate, the more expensive the penalty can be. BIG Banks (Royal Bank, TD Bank, CIBC, Bank of Montreal, Scotiabank, National Bank, etc.) all use the Bank of Canada’s POSTED RATE to calculate their mortgage penalties.
None of these financial institutions, however; actually charge the client the posted rate on their mortgage loans. What the bank does instead is provides a discount off of the posted rate, which is then used in lieu of the current discounted rates they are offering to calculate the penalty.
So for example, if your rate is 3.64%, but the posted rate at the time of the mortgage was 4.84%, they use the discount of 1.2% (4.84-3.64).
When it comes to smaller outfits or "monoline lenders" accessed exclusively through the broker channel, they often have similar prepayment penalty formulas except they plug in different numbers. Monoline lenders tend to use lower posted rates (not the Bank of Canada‘s) to calculate their penalties.
So, for example, if you’re rate is 3.64% and the monoline‘s (broker-channel only) posted rate is 3.99%, the discount is only 0.35%. One can see how this would equate to a lower penalty when entering these numbers into a basic formula.
Using a mortgage balance of $280,000 at a rate of 2.99%, taken out on September 1, 2016, and maturing August 21, 2021, let‘s take a look at the difference in calculation based on the borrower exiting January 15, 2019.
With CIBC Mortgages:
Calculation type:Interest rate differential
Learn more: Information on mortgage prepayment (open in a new window)
Remaining term:2 year(s), 8 month(s)
Comparison rate:3 year, 3.940%
Current Interest Rate:2.990%
Rate discount received:1.850%
including cash back:$6,675.84
With a monoline lender (First National Financial LP)
(Example of calculation below)
Your estimated prepayment charge is
There is definitely no debate about which lender has a better prepayment calculation.
Sometimes borrowers feel comfortable sticking to a major bank out of security and safety. It is a myth that big banks are safer than monoline lenders. If your lender should go bankrupt, they’ve already given you the money!
The proof is always in the pudding, and the argument about prepayment penalties is clear.
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Sarah A. Colucci
I have over a decade of mortgage experience. I am passionate about helping my clients obtain the best mortgage and getting out debt as soon as possible.
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By: Sarah Colucci
Senior Mortgage Agent, Lic. M14000929