Standardizing Mortgage Penalty Calculations

penalty-standardizationTwo years ago, the government pledged to “standardize the calculation and disclosure of mortgage prepayment penalties.”

It addressed the disclosure problem last week (see: New Mortgage Penalty Disclosure), but it has done nothing to standardize the actual calculation itself.

This lack of action irritates some consumer advocates. They feel that lenders’ convoluted, algebraic penalty formulas allow them to overcharge people. (How to define “overcharge” is another question.)

As to why the government chose not to standardize penalty calculations, a Department of Finance (DOF) official told us:

Mortgages can have a variety of mortgage prepayment calculations.  Standardizing the calculation of the mortgage charges could have resulted in changes to lenders’ product offerings and created a disincentive for some lenders to offer discounted rates to the most creditworthy borrowers.

The DOF concluded that, “This would not have been in consumers’ best interests.”

Instead, the DOF says “The Mortgage Prepayment Information Code of Conduct focuses on disclosing key mortgage prepayment information that equips consumers to understand and benefit from a choice in mortgages.”

Unsurprisingly, that leaves two camps in the penalty standardization debate: Those for it and those against it.

standardized-mortgage-penaltiesPro-Standardization

Some people are outraged at the thought of banks profiting from mortgage penalties. We’ve all heard stories of eye-popping, prepayment charges in the tens of thousands of dollars.

There are many people who would therefore like to cap mortgage prepayment fees.

Others would prefer to see a standard penalty formula that is applied consistently regardless of the lender. In this case, breaking a mortgage with a given mortgage amount and interest rate would trigger the same penalty regardless of the lender.

Another idea is to allow lenders flexibility in how much they charge, but to legislate the penalty range and calculation method. In that case, all lenders would calculate the base penalty the same way. They could then charge a simple multiple (e.g., 1X, 2X, etc.) of that penalty at their discretion, subject to:

  1. The base penalty formula being straightforward
  2. The multiple being disclosed up front
  3. The total penalty not exceeding the maximum allowed by law.

The Case Against Standardization

mortgageThe original intention of mortgage penalties (more accurately called “interest compensation charges”) was to make a lender whole if the borrower backed out of a mortgage contract that he/she voluntarily agreed to.

Without such compensation, the lender would have less ability to cover costs and repay depositors and/or investors who provided the money to lend to the borrower.

Put another way, a mortgage penalty is similar to the compensation we might expect if we bought a 5% GIC and the bank cancelled it when rates dropped to 2%. We’d demand the rate we had been promised, especially if there were no place left to invest at a similar yield.

Most of the time, mortgage compensation charges are not the cash cow people think they are. (There are exceptions, of course.) Last quarter, for example, CIBC reported that its prepayment fees collected from customers were actually lower than the true breakage costs to the bank. That appeared to be an industry-wide trend, according to CIBC’s earnings release.

In many cases, when a customer breaks his/her contract, penalties only cover the interest a lender loses; lenders incur many more expenses when a mortgage is broken. Lost interest is just one.

equal-penaltiesFurther, many would argue that standardized penalties are self-defeating. Forcing lenders to apply a single penalty formula for early termination would restrict lenders from charging what they deem necessary to become whole.

That one-size-fits-all penalty would likely drive lenders to add a rate premium to every single mortgage to compensate for the lost interest revenue. No one would be further ahead, monetarily anyways.

In a free market where mortgage lenders can generally choose what interest rate and fees to charge, it’s difficult to justify legislating a specific calculation method for interest compensation. Lenders have different costs, different mortgage features, different mortgage flexibility, and different profit margins. Being forced to levy the same penalty for a given rate and loan amount makes little business sense.

Mind you, some lenders might be able to tolerate a compromise in which a set method is legislated for calculating a range of penalties. In that case, all lenders would determine the “base penalty” the same way, based on the borrower’s contract rate term remaining, and standard comparison rates. A lender could then charge some multiple of that base penalty, up to a regulated maximum. This system would help borrowers compare lenders’ penalties more easily, while still providing flexibility for lenders to recoup costs as needed.

***********

A mortgage contract is a contract like any other. It is voluntary and it binds all parties. As a borrower, one can always choose a lender or term with a less onerous penalty. (That will now be easier to ascertain thanks to the government’s new penalty disclosure rules).

As to whether the DOF will reconsider enacting standardized mortgage penalty calculations in the future, it told us simply: “The Government will continue to monitor mortgage charges.‪‪‪”


Rob McLister, CMT

  1. Sounds like a good idea to standardize but with the option of adding a multiple. This would make it easier for consumers to understand and know what they are getting into at the beginning of the contract. I imagine contracts with a larger multiple would be able to offer slightly better rates than those with smaller multiples. It’s kind of like the how the APR allows a consumer to compare overall cost.

  2. New disclosure legislation’s purpose is (ideally) to assist the borrowers in understanding more clearly their mortgage contract. But equally important is the form of such disclosure that SHOULD allow easy comparison of features among all lenders.It is this second area that seems missing (at this point). Whether it is a standardized format ( not necessarily the preferred) or as you suggest, a benchmark reference calculation, it is a shame to introduce incomplete disclosure regulations

  3. Variable open mortgages are the cheapest in the long run. I’ve been doing it for well over a decade now.
    Financial agility and no nasty surprises are worth the extra little paid in interest.

  4. Avoiding the IRD is why I still think variable rates are attractive. Of course, whether the IRD will apply to mortgages funded at 2.99% for 5 years, who knows.
    Appraiser – Closed variable is typically your better option vs open, as you pay a premium on the rate to avoid the 3 months interest penalty.

  5. My belief is that clarity is the most important issue. I feel lenders are not transparent on the way penalties are calculated. Even though there is a formula, every lender interprets the formula in a different way thus there is no way upfront were a consumer can know exact how much the penalty will be. That is why as mortgage advisors we need to re-direct the consumer to their bank to get a quote on their penalty when there is a need to refinance. Any comments on this?

  6. Wonder how much it cost the big 5 to have the statement made by DOF that it’s not in the best interest of the consumer…

  7. Sorry Rob, Camilo is right. Transparency and clarity is the issue, not standardization. No one in a legal contract objects to fulfilling their responsibility — as long as it’s clear what that responsibility is.
    That’s also why no one objects to “3 month’s interest” penalties. They’re dirt simple. If banks were totally upfront what IRD calculations were and how they are calculated (described in plain language rather than legalese terms like “wherefore” and “notwithstanding” and slippery hedges like “the greater of” and “may change from time to time at our discretion”) people would develop more respect for lenders.

  8. Hi yreppilskanb,
    No need to apologize. I don’t think anyone is arguing against your point–certainly not us. :)
    Standardization was the specific issue explored in this story. We’ve discussed penalty clarity (or lack thereof) in other articles.
    If you search the archives, you’ll find that we have long been critical of lenders for being more translucent than transparent when it comes to penalty calculations.
    Cheers…

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