Date Posted: November 30, 2017
No one ever thinks when signing a new mortgage that there may be circumstances in the future that, unbeknownst to them, may cause them to break their mortgage contract early. In fact, nearly 68% of mortgage are paid off either entirely or replaced by a new mortgage before the end of their term. That’s nearly 68% of people incurring a penalty.
This is why, when working with your Mortgage Broker, it is important to discuss not only the rate, term, and type of mortgage but also the pre-payment privileges and penalty calculations.
Prepayment privileges are a feature of most mortgages which allows you to make lump sum payments towards the balance of your mortgage or allow you to increase your mortgage payments to help pay down your mortgage faster. However, not all mortgages offer the same percentage of prepayment abilities.
This is the penalty you will need to pay if you choose to break (or payoff/transfer/refinance) your closed term mortgage before its maturity date. A few limited featured mortgage products with certain lenders do not allow you to break the mortgage at all before the end of your term unless you have sold the property, it is important that you know if your mortgage can be paid off prior to maturity or not.
These are the two most common methods for calculating a prepayment charge on a fixed term mortgage; typically most lenders state that their penalty is the higher of:
• Three months’ interest: an amount equal to three months’ interest on your outstanding mortgage balance.
• Interest rate differential (IRD): an amount based on the difference between two interest rates. The first is the interest rate for your existing mortgage term. The second is today’s interest rate for a term that is similar in length to the time remaining on your existing term. For example, if you have three years left on a five-year term, your lender would use the interest rate it is currently offering for a three-year term to determine the second rate for comparison in the calculation.
Not all lenders calculate their Interest Rate Differential (IRD) calculation the same.
Options 1 and 2 above, using the posted rate as the comparison rate, or adding back the discounted rate both result in a higher cost to you if you break your mortgage. If all else is equal, we would usually recommend a mortgage from a lender where the prepayment penalty is based on the lower calculation method in option 3. Many factors are considered when choosing a lender, sometimes because of more beneficial interest rates or because of certain approval criteria, a lender with the 3rd method of calculation is the best choice for your mortgage.
The difference between the more expensive calculations described above in scenarios #1 and #2 and the calculation method used for scenario #3 can be tens of thousands of dollars. This is a good discussion to have with your Mortgage Brokers Ottawa agent.
Most lenders calculate the prepayment penalty on a variable rate mortgage to be three months’ interest.
Porting Your Mortgage
If you have decided to move to a new home during your mortgage term you may be able to port your existing mortgage which would help to avoid incurring a penalty for breaking your mortgage. This is a feature that not all mortgages offer and once again, it is best to consult with your Mortgage Broker to get all the information beforehand.
There is more to a mortgage than the rate; working with a Mortgage Broker to help understand the differences in each product may save you thousands in the long run.