Thursday, March 18, 2010

Mortgage Penalties: IRD vs 3 Months Interest Payment

Original posted on

We all know mortgage rates are near all time lows and that rates will inevitably go higher. Long term bond yields, which affect fixed mortgage rates, have increased over the past few weeks, so we’d expect fixed rates to increase as well. But that didn’t happen. Many of the big banks are doing a massive market share push right now, and have surprisingly decreased fixed mortgage rates despite bond yields increasing. Variable rates have stayed constant as the Bank of Canada recently re-iterated there conditional commitment to keep them at this level until the summer, although we’ve seen a slight increase in the discounts to prime with a Prime – 0.55% or 1.70% 5 year variable come out last week.

This has resulted in people starting to prepare for the rate increases, and much talk in the media over the past week about mortgage penalties. When you take out a mortgage, it is a contract that comes with a commitment, but like many contracts, there is an out clause if you’d like to terminate the contract early. However, that out clause comes at a price – and this is the penalty fee.

Historically, the penalty fee has been a payment of 3 months worth of interest, but some lenders use the higher of 3 months interest or an IRD or “interest rate differential”. The IRD is based on the difference between your original interest rate and the interest rate that the lender if they were loaning the funds out today. Some banks cheekily use the posted rates to calculate this differential, although that is usually not the actual rate people get for their mortgages.

As different lenders use different penalty calculations, it can be difficult for consumers to know how much the penalty is. As a result, the government announced in the recent budget that as a move towards greater “consumer protection” they would look at standardizing how lenders disclose and calculate prepayment penalties. This is applicable to fixed rate mortgages as variables don’t have IRD penalties.

IRD calculation

Here is an example of how to calculate the IRD:

  • First, take the principal balance, multiply it by the difference between the previous high interest rate and the newer low interest rate [i.e. if the old higher rate was 5.5%, but now is 3.5% = 2%]
  • Divide that by 12
  • Multiply that number by the remaining months on the mortgage term to get the approximate IRD payment owed
  • IRD vs 3 months interest

    If you’re looking at refinancing to break your current mortgage and move to a lower rate then you simply need to:

  • Calculate the IRD penalty
  • Determine how much interest would be paid on the current mortgage rate and term
  • Compare that to the interest that would be paid with the newer rate

    If the IRD is less than the savings between the two rates then it could be worth switching.

    The refinancing penalties have become such an issue that the Ombudsman for Banking Services and Investments (OBSI) has seen a rapid increase in the number of new cases that have been reported. In the most recent quarter they received 301 complaints, which is almost twice the number received in the same quarter last year and three times as much over 2008.

    So if you’re considering refinancing, find your mortgage documents, see what type of penalty you have to incur to break your current mortgage contract, do some quick calculations and then as always speak to a mortgage specialist before making any final decisions, and in this case, to make sure your calculations are correct.

    Happy refinancing.

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