Penalty Calculations—The Missing Pieces

Mortgage-PenaltiesWhen a Certified Financial Planner (CFP) can’t figure out how to calculate his mortgage penalty, it’s got to be really tough for Joe Borrower.

Globe & Mail columnist Ted Rechtshaffen, a CFP, recently wrote about this very topic. He says: “My mortgage breakage cost truly is a mystery…I have read my mortgage contract…It can’t be found in the fine print.”

Like many banks, his (TD Bank) explains how to calculate its penalty, but people have to deduce the numbers to plug into the formula themselves.

Those numbers include:

  1. The contracted interest rate (easy enough)
  2. The posted rate at origination (not as easy)
  3. The months left on the term (easy)
  4. The relevant comparison rate (not as easy)
  5. The current mortgage balance

To confirm these numbers, the borrower generally has to call his or her lender.

Wouldn’t it be nice, however, if you could log into your lender’s website and get this information with one click? It would, but lenders would much rather you call them for it. That way they can try to sell you a new mortgage.

A key point Rechtshaffen makes is that some lenders go out of their way to muddy the waters with respect to mortgage penalty calculations. They do that by:

  • Not including certain inputs for calculating your penalty in their mortgage contracts (like the posted rate); and/or,
  • Not telling you where to get the inputs on your own; and/or,
  • Not clearly explaining (with examples) which term to use when determining your comparison rate; and/or,
  • Writing penalty explanations in language that almost requires a law degree.

Mortgage-Penalty-CalculationPenalty calculation shouldn’t be this cryptic. CAAMP says that 47% of people who refinance before maturity have to pay penalties. (It’s actually more than that if you include refis with blended rates [which have penalties built in].)  So it’s not like this is some infrequent obscure need that borrowers have.

Lenders who believe they have their customers’ best interest at heart should provide a web page that clients can log into. It should provide an instant penalty quote, with a comprehensible explanation of how that penalty was calculated, showing the math.

RBC has a semi-workable solution with its penalty calculator. Unfortunately, you have to fill in the blanks yourself and few people will know what to enter for things like the “Discount off posted rate.”

In any event, one of the nice benefits of not getting a big bank mortgage is that your penalty is often based on discounted rates instead of posted rates. That often saves people hundreds or thousands of dollars. It’s even more meaningful given that most people break their five-year fixed terms in 3.5 to four years on average.



Sidebar:  Be aware that some smaller lenders (like Industrial Alliance, Bridgewater Bank, etc.) have more complicated penalties, sometimes based on bond yields.

At times, those penalties can be even more painful than a big bank penalty.

This all goes to show the importance of discussing penalty policies with your mortgage planner…before settling on a lender.

Rob McLister, CMT

  1. The Inflating factor for IRD (penalty) amount most of the time is the “fake” discount – posted rate minus your rate reduction – the greedy bank have included in your contract.
    Here’s an example :
    YOUR FRIEND can get today 5 year fixed term from ING for 3.64%.
    YOU can get 5 year fixed term from RBC for the same rate after you call them, but in your mortgage contract they will write that they gave you a reduction of their posted rate 5.29%. “The discount” is 1.65%.
    So no biggie for you UNTIL YOU decide to break up your mortgage or even decide to change your term and stay with RBC. They have no mercy even if you stay with them.
    So that discount goes into the formula and changes the numbers sometimes dramatically.
    the ING user where there are no “Rate discounts” always have smaller or same prepayment penalty, sometimes difference is thousands of dollars.
    10 K penalty with RBC vs 4,5 K penalty with ING for same mortgage. This is a real life example from 2-3 years ago for 2 borrowers with same mortgages, same rates, one at ING, other at RBC.
    Please note that above example was for the time when 5 year fixed market rate was around 5 %.
    On the today’s around 3% rates this won’t happen as most likely the difference from today’s (the day you decide to break your mortgage) rate from the rate you have is not that big and you most likely will end up paying 3 months interest on both lenders.
    Either way I think this Fake “discount” RBC writes in your contract is wrong as you have actually took a normal market rate, not a promotional rate.

  2. The thing is that whatever they say one day, the next may be bigger or smaller. And they have no explanation (at RBC). They say – We use a calculator, not sure how it’s calculated, so when all numbers are seemingly the same one day you have one penalty, the next is higher sometimes.

  3. “I think this Fake “discount” RBC writes in your contract is wrong as you have actually took a normal market rate, not a promotional rate.”
    Yep. This is the #1 reason banks still quote posted rates.

  4. I recently broke a mortgage with CIBC (PC Financial, in reality) and fell victim to the dreaded IRD penalty. I had no problem with the penalty in concept since I signed a contract and agreed to compensate CIBC if I left before the five years was up. Fair is fair. My problem was that, even though I am actually a mathematician, I did not have the information that I needed to calculate the penalty. I had to call the lender and deal with all the peripheral nonsense… pleas for information, attempts at renewal, etc. In the end, I did what math I could and kept my fingers crossed that, on the payout day, the variables had the values that I was given previously on the phone. It was, in a word, stressful.

  5. Rob brought up excellent points! The banks (as well as other lenders) would never make the IRD language easier to understand unless the government makes it a law. The reason behind their logic is simple: to get the customer to call or go to the branch where they can sell the client another mortgage, often by blending rates which is merely blending the penalty into the new mortgage.
    Here’s an easier tip for consumers who traditionally take a 5-year fixed mortgage and want to avoid an expensive IRD: take a shorter term! Seventy percent of those who lock for 5 years collapse the mortgage after 3 1/2 years. So why not take a 2- or 3-year term from the onset? Another option is to choose a variable rate mortgage where the penalty is a more modest 3 months interest and keeping the payment amount as a 5-year fixed.
    Another tip is always get the penalty quote directly from the lender (don’t bother calculating it yourself because it’s specifically designed to throw you off), in WRITING, and as closely as possible to the payout date.
    The bottom line is consumers HAVE options when it comes to avoiding a costly IRD penalty and it’s best to be proactive (as in getting the right mortgage from the onset) as oppose to being reactive (tearing your hair out trying to figure out how your lender came up with such a huge quote).

  6. the benefit of Open mortgage for me isn’t that obvious as an initial solution.
    The loss from Higher rate outweighs the benefit of free switching.

  7. ” The banks (as well as other lenders) would never make the IRD language easier to understand unless the government makes it a law.”
    I totally agree with that. More regulation will help to protect uneducated consumers.

  8. Agreed, except that the Gov’t did in fact make new rules around this calculation. It was supposed to standardize the industry for IRD penalties. That was 2010, and no standardization yet…..

  9. I fought with the RBC calculator for a while and I can almost get their results with my own calculations. I’m off by about 1% on the IRD penalty amounts. Maybe the difference is assumptions about number of compounding periods.
    The real issue here is manipulation of the discount amount. If discounts are smaller when interest rates are lower, then the rate used to compute the IRD present value will be consistently too low and the IRD amounts consistently higher than a fair level.

  10. It’s okay to ask a mortgage agent how to compute the penalty calculations so you know where your money goes. It may be difficult to figure out at first, but once you’ve learned the twists and turns of calculating, you won’t get confused.

  11. my question to the mortgage experts still remains the same………why would it be considered fair for the big banks to calculate the penalty as 3-months interest in situations when you are renewing only a couple weeks early to catch a good fixed-rate.

  12. Hey rj0002
    I wanted to clarify part of your question… when you say “renewing” are you talking about with the same lender? Or were you referring to “transfering” at or just before maturity to another lender?
    I have worked for 3 of the big 5 banks and in my experience all of the big 5 banks allow you to renew your mortgage up to 120 early of the terms maturity date to take advantage of lower rates withour penalty.
    However if you want to switch lenders at maturity without a penalty this must be done at maturity date… that is were the rate hold at the new company will assist you.
    AS for the penalty it is 3 months interest penalty to break you term only when IRD does not apply unless you have less than 3 months remaining for which you would have to pay all the interest for the full time remaining.
    Hope that helps

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