With mortgage rates near all-time lows, many people may consider renegotiating their mortgage, refinancing with another lender who may be offering a better rate, or selling their property so that they can upgrade while rates are low. What you must pay as a penalty should be a key consideration when determining whether refinancing or selling is a financially sound decision. Take the time to determine your penalty amount before making any commitments to other lenders or before deciding to list your property for sale.
As a quick primer, mortgages are either open or closed. Open mortgages can be repaid at anytime without a penalty payment. Closed mortgages are subject to a penalty payment. The penalty amount will depend on what amount is repaid prior and when it is repaid. Most closed mortgages have a two-pronged penalty clause applicable to full payouts: there is the standard “3 months interest” penalty; and then there is the poorly understood “Interest Rate Differential” (IRD) penalty. When paying out your closed mortgage prior to the expiry of the term, the higher of these penalties will apply.
It’s relatively simple to determine a reasonable estimate of the amount of a three month interest penalty – just look at your monthly mortgage statement to see how much interest you paid and multiply that by 3. However, determining the potential IRD penalty is more tricky. To determine the IRD penalty, you must know several facts: the outstanding principal to be repaid; the interest rate payable on the mortgage; the interest rate payable now for a similar mortgage; and the number of months remaining on the mortgage term. Essentially, the IRD amount will be equal to the amount of interest income the lender loses by having you prepay your mortgage.
For example, if you are repaying $200,000 which is presently at a rate of 5% with interest rates now at 4%, a lender is going to have to lend this $200,000 out to a new borrower at 4%. The loss to the lender is 1% of $200,000 for the balance of the term. If you had 36 months left on your mortgage, your IRD penalty would be $6000. Compare this to the penalty applicable under the 3 months interest penalty (in this case, $2500) and you see that the IRD penalty, will be a significantly higher amount. You must factor this in when weighing whether or not to refinance, or when trying to determine the amount of cash in your pocket after your property’s sale.
IRD penalties resulted in some large and shocking prepayment penalties several years ago as rates started to steadily decline from 7% to these present all-time lows. We’ve seen $30,000-$40,000 penalties when a client was expecting to pay the 3 month interest penalty of only several thousand dollars. Thankfully, as rates rise over the coming years, IRD penalty amounts will decrease because lenders will lend the money you repay to someone else at a similar or higher interest rate. If the rate in existence at the time you repay is higher than the amount you are paying, then the IRD penalty will not apply because the lender is able to make a higher interest rate off a loan to a different borrower. So, the good news in rising interest rates is that you may end up having to pay a lower prepayment penalty. If rates remain low, those who have mortgages locked in at over 2% above the rate in existence at the time you would have to repay the mortgage may be well-advised to ride out the term rather than refinance. We highly recommend speaking with your lender or broker to determine the correct amount of a prepayment penalty prior to making your final decision to refinance or sell your property. Knowing the prepayment penalty amount will be a key factor when making your decision to sell your property, as the prepayment amount may very well be a big hit to your bottom line.
Tip of the Day: One of the ways to avoid paying the penalty at all is to stick with the same lender. Some lenders will waive the penalty or will credit the amount of the penalty back to you provided that you maintain your relationship by taking out a new mortgage with them on your new property.
Dave
