The much-unloved Interest rate differential (IRD) penalty is a mystery to most of the natural born population.
People loathe it, largely because they don’t understand it. We continually come across folks who read their entire mortgage contract and are still confused by the IRD calculation.
Fortunately, federal disclosure guidelines are on their way later this year. These guidelines are supposed to standardize the explanations of IRD penalties to make them more comprehensible.
There is one element of the IRD calculation, in particular, that gets people all tied in knots. It’s called the “comparison rate.”
Here’s a real-life example of how the comparison rate can spoil your day: Customer fee to pay out mortgage doubles (CBC News).
The story features a regular guy (Mohsen Movahed) who learned how to calculate an IRD penalty…the hard way.
It seems Movahed relied on a penalty quote, only to find some months later that his penalty had doubled.
The culprit, says his bank, was the comparison rate used in the IRD calculation.
A comparison rate is the rate a lender compares to your current contract rate in order to calculate the IRD penalty on a fixed-rate mortgage.
The comparison rate is usually the lender’s rate for the term that most closely matches your remaining term.
For example, if you have 22 months remaining on your fixed mortgage, a lender will typically (there are exceptions) use a 2-year term as your comparison rate.
The kicker is that banks often subtract the discount you received at origination from their posted (comparison) rate—which makes the interest rate differential and penalty even worse!
Some lenders use bond yields for their comparison rates (example). This method can sometimes be far more costly depending on yields and mortgage spreads.
Conversely, some non-bank lenders use regular discounted rates for their IRD calculations, which can be more favourable for the customer.
In any case, Mr. Movahed discovered that the comparison rate can drop considerably as time goes by. That drop can boost the interest rate differential and cost you thousands more.
As a sample test, we ran a quick penalty calculation for breaking a hypothetical $250,000 mortgage. Our example was based on actual historical and current bank rates. It assumed the customer had about 2.5 years remaining on their term and had received a 1.50% discount off posted rates.
Depending on the effective date of the penalty calculation, a bank could quote the penalty based on either a 2-year or 3-year comparison rate. That’s relevant because the penalty difference between these two comparison rates (as of today March 24, 2011) is more than $3,700!
In other words, if our hypothetical customer waited until she had slightly less than 2.5 years remaining in her term, the bank could apply the lower 2-year comparison rate (instead of a 3-year) and her penalty would increase 28%. (A lower comparison rate makes the IRD bigger.)
The moral is that timing matters when calculating an IRD penalty. A good mortgage advisor can help you plan properly to minimize the IRD, if and when you have to pay it.
Rob McLister, CMT
Also lots of people think “asking” about their penalty is all the have to do. If rates decrease after you’ve made an inquiry, your penalty quote will increase and your penalty amount isnt “held” for you until a lender receives an official request for discharge.
Great Post, Rob. For the average consumer its worth noting that IRD penalties do not apply to closed variable rate mortgages. Thee penalty is just 3 months, simple interest.
Wow, we really don’t understand how good we have it in the USA! In Wisconsin, prepayment penalties are not legal on mortgages. I would think a bank could lend money like they do here in Canada, still make money, and beat the socks off the competition. Of course, I don’t know all the details so that may well be naive!
Good post Janet. Though here in Canada we pay no origination fees to setup the mortgage. If there are any costs generally the lender will cover them.
What makes is worse is with the MRQ rate the government is forcing clients to take five year rates which can cause big penalties in the next few years if the the spread between short term and long term don’t change. Having clients who took five year rates below 4% getting nailed now with IRD penalties. Who would have thought. Time for the government to step up the legislation to set standard penalties.
Great post for the general consumer. This is one of the many reasons, people should go for a variable mortgage instead of a Fixed rate!
The best way to avoid this IRD is to get a 1 year fixed rate mortgage!
When the goverment finally makes changes to the Interest Rate Differential, watch out for the banks to start charging fees to break the mortgage.If there is a loop whole for the banks to charge more they will find it.
This is very true:
“The kicker is that banks often subtract the discount you received at origination from their posted (comparison) rate”
The problem is that in some mortgage contracts (eg: TD) the word ‘discount’ is used in the contract without any further definition. The contract does not state how ‘discount’ is calculated. A customer can clearly assume this is the ‘discount’ received from the advertized discounted rate, not from the posted rate.
@Janet Johnson, that being said we don’t pay any taxes on our principle residences when we sell, and I believe in some states they are charged. So I’d rather pay a penalty of $2000-20,000 and avoid taxes on, say, a $100,000 profit on my principle residence.
@ banker in an ivory tower Not all variable-rate mortgages are 90-days interest. Have you (tried) to read a mortgage commitment from Industrial Alliance? you’ll need to be a PhD to understand it.
Interest rates have only one direction to go…. UP.
It’s very unlikely anyone will be paying an IRD penalty over the next few years.
I would gladly pay the origination fees for a 30 year fixed mortgage at 4% with the ability to pay it out anytime.
Maybe so, but I’m better the years of mortgage interest deductability would save you more in taxes than the capital gains on $100,000 as most people would pay at leaset 100k in intersted over the life of their mortgage.
Correct me if I’m wrong but even if rates go sideways the IRD can still be more than 3-months interest?
Jake/Dave, the first $250k profit is exempt from federal taxes($500k for a couple), dependent upon 2 yrs ownership. For less than 2 yrs ownership, the exemption is reduced proportionately.
See worksheet 3 at the following link.
Rob, or others, correct me if I am wrong, but do not some lenders round any remaining term UP to the full year? IE, 2 years and 2 months remaining triggers an IRd calculation based on 3 years remaining.
Some round up. Some round down. Most use the closest term.
A few greasy lenders have IRDs on their variables too.
Try asking the bank for the actual calculations. We as mortgage brokers dont always have access to the rates that were in effect at the time. So therefore banks can .. without anyone regulating them charge whatever they want.
I habitually ask my clients to ask the bank for a copy of the calculations that were used to calculate their penalties. The CIBC sent one of my clients a page out of their manual quoting the algebraic method but not the figures used. 90% of the clients were not successful and simply frustrated by the entire lack of information. It stands to reason if they received a discount then that rate would also be discounted which can result in higher penalties, but many of my clients state they never received a discount. I have worked with IRD’s for years and understand very well how they work, and some of the penalties I was seeing prompted me to write to my MP. I was informed by my MP that .. IN CANADA THERE IS NO REGULATORY BODY to oversee mortgage penalties and as long as they do not exceed the 60% interest rule the banks could virtually charge what they like… Amazing isnt it,
The other thing I learned from them is there is no governing body for the beacon score such as there is in the US for FICO scores. ….. Go figure
Thanks for the post. I completely echo the frustration.
Banks are required to calculate the IRD as per the client’s mortgage terms. However, you are very correct in suggesting that lender personnel are frequently ineffective in helping customers determine the inputs for the IRD. They can quote a total penalty, but they often cannot explain the calculation behind that number.
Federal disclosure rules cannot come too soon. Unfortunately, I think the government underestimated how many nuances exist and how long it would take to draft the actual regulations.
Can someone help me, I got talked into a 30year mortgage on a ten year fix term. I want out and read on here about the Canada Interest Act. It said that on a ten year term that after 5 years that the lender can only charge the 3 months interest and that the IRD could not be applied. Where can I get the Interest Act and what section do I need out of it?
See section 10(1)
Be very careful. They’ll likely try to convince you that IRD applies but yes, you can get out AFTER five years have passed by paying three-month’s interest.
If you break the term BEFORE you’re into year five, however, all of the remaining years will feature in your interest calculations. For example, if you’re in year three of ten, your IRD will take into account the lost interest for years four through ten of your term. Ouch.
We considered a ten year term at 4.85 percent but the prospect of owing what could amount to more than 50 000$ (in our case) if we had life-changing event requiring us to sell the house in years one through five was more than we could stomach.
I don’t agree that the banks can charge “what they like”. The bank is bound by the mortgage contract. The problem I mentioned earlier is the description of the IRD calculation in the mortgage contract is too vague. The contract can refer to parameters such as ‘discount’ without explicitly defining them. I wonder how a bank with it’s army of lawyers draft such a vague description? Is this intentional?
The federal government has a problem with the debt consumers are incurring, yet part of that debt is the paying for userous penalties by the banks. The largest penalty I have seen is $21,000 to get out of a mortgage. The banks are stealing the equity of Canadians and there are no regulations which make them accountable. This has to stop now and Canadians need to speak up. The banks have too much control in this country and the federal government has become their puppet. Look at how many times the Federal Minister discusses rates rising..lock in…when in fact they have done just the opposite. I would like to see a figure on how many billions of dollars of the banks profits have come from the backs of Canadians through penalties. It has been a cash cow for the banks and you watch they arent about to give it up. Legislation hmmmmm!
As a Real Estate investor, we have been hit multiple times with mortgage payouts when selling properties. The largest we have been hit with s $17,000, but another investor I talked to was quoted a payout of $40,000 on a property he needed to sell.
These payouts trap many homeowners and essentially steal their equity. If banks weren’t posting such huge profits I could see how this is an actual cost to them, but from all outward appearances it is just a cash cow.