I have been a mortgage broker for 12 years and one item that I have explained many different times to my client (along with the differences between a fixed and variable rate mortgage) is the difference between pre-payment penalties. More specifically, I answer the question: what is an interest rate differential (IRD) penalty.
In summary, variable rate mortgages only carry a 3 month interest penalty, but fixed rate mortgage penalties are more complicated, with the penalty being 3 months interest OR interest rate differential, whichever is greater. Each lender has their own method of calculating an IRD penalty, and this penalty can vary greatly from lender to lender.
The reason for an interest rate differential penalty
To understand what the interest rate differential penalty is, you should understand about how banks obtain capital to lend as a mortgage. Variable rate capital is obtained in the short-term money markets, and is tied to the Bank of Canada prime lending rate.
Fixed rate capital is obtained from the bond market. Mortgage lenders obtain their money, build in a mark-up on the rate for overhead and profit, and then offer the mortgage at the rate that you are borrowing at when you obtain your mortgage approval.
To obtain a guaranteed mortgage rate for 5 years, the mortgage lender issues a 5 year bond. They are obligated to that bond rate for 5 years. If the bond market yields decrease, then market interest rates go down.
If you as a mortgage borrower want to refinance to get a better mortgage rate elsewhere (because rates went down), it means that they are stuck with a bond that is more expensive than current market rates. They will then lose money when they lend out that money again at market rates. So how do they compensate for that loss? By charging you the difference between what the money is costing them and what it is now worth. It seems fair, right?
Not all interest rate differentials are created equal
So now that you understand the reason for an IRD penalty, you should know that not all IRD penalties are created equal. The chartered banks generally have a way of calculating an IRD penalty that is extremely punitive in nature. Non bank lenders tend to have less punitive IRD penalty calculations.
So how do penalties vary so much between chartered banks and non-chartered banks? Chartered banks in general compare the posted rate of the mortgage that you have and compare it to the posted rate of the remaining term. As an example, if you had a 5 year term and 2 years paid off of it, then your penalty would be calculated based on the 3 year posted rate.
I will give you an example. As of the date of this writing (Jan 15, 2019) assume you have a mortgage balance of $500,000 on a fixed rate of 5 years at an interest rate of 2.99% with a maturity date of January 15, 2022. The posted rate at that time for a 5 year fixed rate term was 4.64% (it is now 5.34%).
Suppose in this example, that you had your mortgage with CIBC. Using their mortgage penalty calculator, the estimated penalty would be $11,060.23 (you would be the fortunate beneficiary of rates having increased in the last 2 years, or this number could be far greater).
Now, lets assume I arranged the mortgage for you, and the lender was our own internal mortgage brand, Blueprint. Below is their mortgage calculator:
The IRD calculation was a negative number, meaning that it is not applicable in this case. The CIBC mortgage penalty was $7,322.23 more!
Why is this? In general, chartered banks will take the posted rate, and subtract a discount to give you your mortgage rate. In the above example, the posted rate at that time was 4.64% and the discount was 1.65%, for a rate of 2.99%. When they calculate the rate for the remaining term, they will compare 2.99% with the three year posted rate MINUS the discount. That rate would be (3.94% – 1.65%) 2.29%. Then 2.99% minus 2.29% is 0.7%. They then take that interest rate differential and multiply it by the remaining balance, then multiply it by the number of years remaining. Do you believe that they are offering the public a 3 year fixed mortgage at 2.29%? If you do, I have some swamp land to sell you.
With Blueprint, they take the rate you have and compare it to the rate that they offer for 3 years to the public. In this case, 2.99% minus 3.79%. As this is -0.8%, then the 3 month interest penalty applies. Many of my lenders calculate penalties in this manner, and most banks and credit unions calculate penalties like CIBC does.
I work with banks and credit unions among the lender choices I have for clients, and sometimes their option is the best option. However, it is best to know what you are getting into when obtaining financing from a bank, and a good mortgage broker, such as myself, can help you with navigating such landmines as the IRD penalty.
The above is an example of the value that I add to my clients when I am working with them. The penalty on such a mortgage would result in you effectively paying 1% higher interest rate on your mortgage. My job is to help to ensure that that does not happen to you or that you are aware of why it is still the best option for you. Do you believe that an employee of the chartered bank who arranges a mortgage for you will warn you about things such as this, or work with your best interests in mind?
Contact me and you can rest assured that I will do the best I can to get you the best deal for you and give you advice that you can trust.