Want to Get a Better Mortgage Rate? How to Calculate Your Mortgage Penalty

By Brennan Valenzuela
Ratehub.ca


Current mortgage rates are floating at historic lows, which have many Canadians salivating to refinance their mortgage for a better interest rate. However, breaking your mortgage contract can come with a hefty price tag. Take Ryan for example, who went online and saw a 5-year fixed rate at 2.99 per cent, contacted his bank and was told that he would have to pay a $10,000 mortgage penalty fee to break his current mortgage loan. He had approximately $325,000 remaining on his mortgage with one year left on his 5-year fixed rate of 5.69 per cent. As you can imagine, he was shocked at how much the mortgage penalty amounted to. He figured a charge that high wasn't worth breaking his mortgage contract over, even though the discounted rate was almost half his original rate!


Mortgage Myth
Many consumers are under the impression that their penalty is calculated as the equivalent of three months' interest, but that is only the case when calculating mortgage penalties for variable mortgage rates. For fixed rate borrowers such as Ryan, lenders determine your mortgage penalty by looking at the difference between your existing mortgage rate and their current rate, the outstanding mortgage balance and the number of months left in the mortgage term. This is referred to as the interest rate differential (IRD) and in falling interest rate environments such as ours, usually works out to a much larger penalty charge than three months' interest.

How are mortgage penalties calculated?
Unfortunately, each lender picks what rates should be used in their IRD calculations, whether it is their posted rates or your interest rate. Take RBC and ING for example, RBC will use the posted rate on the day you acquired your mortgage whereas ING will use your actual interest rate to determine your mortgage penalty.
This is why consumers feel left in the dark and flabbergasted with penalty amounts that are much higher than what they expect. What's made matters worse is banks haven't exactly been transparent on revealing what criteria they use to prospective clients. This is a problem which the government recently addressed in March of 2012 that future legislation will require banks to provide online mortgage calculators. ^[1]

An example of a mortgage penalty calculation



Luckily, there are mortgage penalty calculators already available for the public to use, such as those found on Ratehub.ca. The inputs required for the calculator include the original start date of your mortgage, your original mortgage terms (rate, term and type), your total remaining mortgage balance, and your provider (i.e. who lent you the mortgage?).
The best way to stay prepared for a potential mortgage breakage in the future is to understand what you're getting into in the first place. Before signing your name on a mortgage contract, have a mortgage professional break down the fine print to explain how your penalty would be calculated if you needed to break the loan in the future.

Is it worth it?
A low mortgage rate over the right term could save you thousands of dollars in interest, so breaking your mortgage contract and facing the penalty fee may be worth it over the long haul. On the other hand, the penalty amount may be too insurmountable to overcome and thus, might not be worth breaking your mortgage contract over. What should be considered is the interest savings over the remaining term compared to the penalty amount. Additionally, if you do decide to break your mortgage and lock in a low rate, if interest rates increase down the road, your savings multiplies.
Remember, each mortgage penalty is unique, so your decision should be weighed only after a consultation with a trusted mortgage broker or financial advisor.

Sources:
^[1] Department of Finance Canada