IRD Shock

IRD-PenaltyBanks are widely expected to pass along their recent drop in funding cost to borrowers. That should take the form of lower fixed mortgage rates.

Once that happens, some folks will face much larger penalties for breaking their mortgage early.

Generally, as fixed rates drop, interest rate differential (IRD) penalties grow bigger.

Here’s an example…

Suppose you got a 5.50% five-year fixed mortgage three years ago from a Big 5 bank. Assume you received 1.35% off posted rates and have a $300,000 balance today.

If banks drop 2-year posted fixed rates by 35 basis points, that could boost your IRD penalty by roughly $2,400! (The 2-year term is used as a comparison rate because you’d have two years remaining till maturity.)

If you’re breaking a fixed-rate mortgage imminently, you’d be well served to get a discharge statement from your existing lender immediately.

With a discharge statement in hand, you can potentially lock in your IRD penalty for anywhere from 5-30 days (or whatever your lender’s policy is).

Note:  Depending on who your mortgage is with, it’s possible you won’t be able to lock in your penalty until the lender processes your discharge request. That could take up to 5-6 business days in some cases. Consumer-friendly lenders lock in your penalty as of the date you send the discharge request.

IRD typically only applies to closed fixed mortgages, but there are some lenders who also apply it to their variable-rate mortgages. Not cool.

Rob McLister, CMT

  1. Yes, this is why I moved my entire fix rate to my HELOC yesterday. I figured that it was worth the risk.
    Remember to do a lump sum payment before you payout. That reduced my penalty by $300

  2. If you don’t mind me asking Dan, how much was your penalty or do you know the average cost? I’m fortunately in a V rate but wondering for my friends.

  3. I am newbie here. To your experience how fast the banks may make the move? The reason I am asking is I was going to break my term and pay the penalty. My penalty is quite big so I was going to pay down lump sum to reduce it. I just learn my bank will withdraw the lump sum only on the regular withdrawing date and my next payment date is in two weeks! I think I am screwed?

  4. Request a payout statement from the bank, they may lock the penalty for 30days … There is some daily interest you need to pay
    .. Rob, could you conform this, please …

  5. Thanks Adrian for the reply. I don’t know whether I understand you right. But I want to pay the lump sum before requesting the payout statement so that I can lock down the lower penalty? I mean I think I should be able to break the term in time but I want to do the lump sum payment before I break the term to lower my big penalty. But my bank won’t accept my lump sum payment until two weeks later…

  6. Folks,
    Check with your lender about this. Scotia for example won’t take lump sum payments into account if they are made within 30 days of the mortgage being paid out.

  7. Arther, might be better to request payout statement immediately, rather than wait for lump sum to go through. If penalty is that “big”, you might save more if you can reduce the IRD – rather than to save on the interest from your lump sum.
    Again, depends on your situation – if IRD change, or lump sum / mortgage reduction will affect you more.
    I think, in the end if lump sum is better – you would always order a new payout statement. But seeing if you can squeeze in before banks drop might be your best bet.

  8. Once you want to leave, you can count on financial institutions to put additional obstacles in the way. They literally milk you until the last second.

  9. Hmmm…that sounds like a plan. Thanks a lot GC. Yes I can ask for a payout statement to lock the current penalty and as you said if the lump sum ended up to be better I will order a new payout…I deal with Firstline. Just don’t know whether they would allow me to use the payout statement to lock the penalty or they would update (of course increase) the penalty once the fixed rate goes down no matter whether I have my payout statement…I will find out.

  10. Just to add to what Rob said (fantastic post as always), the mathematics to calculate an IRD are relatively simple. It’s the individual policies of every financial institution that are the biggest PITA.
    In an environment of declining rates, the penalty amount increases as the amount of time remaining on the term decreases. Moreover, every lender calculates the differential differently. For example, some lenders will use posted rates (even if offering discounted or discretionary pricing) while others will use discounted rates. Some lenders may round up the term while others will round it down depending on how much time is left on the term and when they received the discharge request.
    The whole point of the IRD is to stretch the spread between the applicable interest rates. The more you can stretch it, the more moolah the financial institution makes. They capitalize on people’s ignorance.
    This is why it’s preferred to work with lenders such ING who have no posted rates. They calculate the penalty based on purely discounted rates and that takes away a lot of the confusion.
    Consumers should also be aware that financial institutions do not negotiate the penalty amount. After all, why would they? They have your signature that provides the bank with a blank cheque to charge as much money as they want (the greater of 3 months interest or IRD) if you intend to discharge the mortgage before the term matures. It’s scandalous! The government should institute a cap! I’ve seen penalties as high as $30,000 for crying out loud. And they deliberately make the IRD incredibly confusing so that the majority of consumers won’t even know how it’s being calculated.
    Some lenders cut consumers a break on the penalty amount if they agree to keep the new mortgage with the same institution.
    Another important tip is some lenders offer an online calculator that supposedly computes the cost of breaking a mortgage if an IRD would apply. Never rely on them! Always get the penalty quote in WRITING and as close as possible to the payout date.

  11. Hi Lior.
    You wrote “In an environment of declining rates, the penalty amount increases as the amount of time remaining on the term decreases.”
    Could you please explain why that is so?
    I am so confused by this IRD craziness!!

  12. Let’s assume that your current rate is 5% on a 5-year fixed rate term and you have 24 months (2 years) left until the mortgage matures. Also assume that 2 weeks ago, your financial institution’s posted rate for their 2-year term was 3%. After the recent interest rate decreases, the institution’s 2-year rate is now 2.7%. Hence, the spread has now increased and so would the penalty amount you owe.
    Assume that you request a payout statement that quotes the penalty. If the lender locks the penalty amount as noted in Rob’s post, you know what the penalty amount will be as long as you pay it out before the hold period expires. If you pay out the mortgage afterwards and rates head down further, your penalty amount will now be higher. On the other hand, if interest rates were to increase, the penalty will be lower as the spread narrows between the applicable rates. The above assumes the lender uses posted rate as a benchmark.

  13. On IRD Penalty calculations; Beware that the large Banks now charge interest rate differential on the Discount you received when you took the Mortgage out. If you negotiate a discount of 1.50% off of the 5 year posted rate, be prepared to pay the penalty based upon the term/time remaining less that same 1.50% discount- what consumers do not realize is that the discount for a 1 year or 2 year is a lot less than 1.50% so they are essentially paying a full 1% extra prepayment by this calculation. Here is an Example: paying out a mortgage with 2 years left and with the original 1.50% discount, you have a 4.19% rate, the posted rate of 3.85% for a two year term today less 1.50% is 2.35%, you will pay the penalty on the difference of 4.19% less 2.35% for 2 years, the effective difference is 2.69%.
    Now look at Broker rates for a new 2 year term today? 3.40-3.65% on average. So you are paying a .96% higher penalty rate based upon a replacement rate of interest that is not available to any consumer at any level of the Bank.
    Read the prepayment information on the mortgage in detail before signing a new mortgage or a renewal notice for this wording.
    I look forward to the Finance Minister standardizing mortgage penalties to protect consumers.
    Additionally, Lenders are stamping the payout statements with “call for formal payout information on the date of payout, statement issued for informational purposes only” to the Lawyer. There is rarely a grace period on IRD unless the Institution misses this.

  14. Hi Adrian,
    Yes. Once the payout statement has been issued, you still have to pay the interest due on the mortgage until closing. That interest is calculated “per diem” (by the day).

  15. A VERY important point that no one has mentioned is that these mortgages have all been sold to “consumers” under the MBS program which program provides us with lower rates and a good supply of funds.
    So which consumer did you want the government to protect? The one who signed up to pay a stream of payments at, say, 5% for 60 months, or the consumer that bought and paid for that stream of payments and interest and you now want to say “never mind”, I changed my mind…..

  16. To be clear, the IRD does not go to “the bank”; it goes to the one holding your fixed contract which you now want to break.
    An important aspect of we mortgage brokers is to give good financial advice. In order to do so, we need to understand the basics of mortgage contracts!

  17. its why NEVER take a fixed mortgage,esp 5yr +, brokers pump 5yr far too much, if your not taking a VIRM -90 these days which pretty much all the Big 5 banks are offering (if you qualify) your not getting good advice

  18. You truly live up to the last part of your name. That is an clueless statement and you have no idea what you are talking about. Brokers recommend a much higher percentage of variable rate mortgages than banks. Get your facts straight before you go out in public pretending to know something.

  19. That isn’t quite true. Only 30% of mortgages are securitized and those are bought predominantly by institutional investors. Much of the rest sit on balance sheets of banks, trusts, credit unions, and large investors. So in most cases the IRD penalty does go to “the bank” or lender holding the mortgage.
    Your underlying point is valid but it sidesteps the real issue. No one is arguing that lenders can’t charge a penalty to consumers who break mortgage contracts. If penalties were disallowed then interest rates and fees would go up for everyone. All people are saying is that penalties should be properly disclosed and commensurate with lenders’ true costs. The individual who said that banks exploit consumers’ ignorance is dead on in this respect.

  20. Thanks for the post. I ha ve two questions for you: My mortgage is up for renewal on 1st December this year. I can now book a rate for 120 days. In light of this post, what term would you recommend to fix? 5 year closed or variable? Second, do you think 10 year fixed rate will go down too ? Sorry for my English, I speak French .. :-)

  21. Hi François,
    10-year fixed rates have gone down a bit already and are expected to drop more in the near term.
    It wouldn’t be possible to recommend a term without knowing more about your finances and objectives. It’s best to speak to a mortgage planner about that directly.

  22. Thanks Bob and Adrian for the information and suggestion. I am working on it now. I think it is going to work out. Thanks again. This website (plus people of course) is wonderful.

  23. Hi,
    Just wondering if anyone knows or had an experience – if I’m at my re-newal date now, can I renegotiate any terms on the contract with my current bank (i.e. penalty calculations etc.).

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