Penalty Avoidance

Photo of a Referee - PenaltyIf you’re getting a new long-term mortgage, odds are you’re going to fiddle with it before maturity.

The majority of people will either:

  • Add money to their mortgage
  • Add a readvanceable line of credit
  • Refinance to get a better rate (which happens less frequently nowadays)
  • Increase the amortization
  • Port their mortgage to a new home, or
  • Discharge it outright.

Some of the above will require an early pre-payment charge (a.k.a. penalty). This week’s Globe column poses ten questions to help you avoid mortgage-penalty shock.

Other things being equal, avoiding lenders with costly penalty rules is one of many ways to reduce your overall borrowing costs.

Incidentally, the industry prefers that mortgage penalties be called “prepayment charges.” That’s because these charges aren’t supposed to penalize a borrower. They’re supposed to compensate your lender for very real costs it incurs when you pay off your mortgage before agreed. (“Costs” refer mostly to lost interest, but lenders also incur underwriting costs, originator compensation, securitization costs, etc.)

The problem is, some lenders impose far more severe prepayment charges than others. Major banks sometimes charge more than twice what a smaller lender would charge for the same term mortgage, even though the bank has lower funding costs. If that’s not “penalizing,” it could have fooled us.

Rob McLister, CMT

  1. Hi there,
    First time writing in. Love your site.
    My question is, if rates stay roughly where they are do IRD penalties still apply? Or do banks charge IRD only if rates fall after your mortgage closes?

  2. Yes, I had the same question. Since most probably rates would go up from here, do we need to worry about the IRD? Wouldn’t it will be just 3 months interest?

  3. Your interest penalty is always the higher of 3 month’s interest or the IRD. Fixed rates have been going up and down slightly over the past few months. So one cannot say 3 month’s for sure until the fixed rates start to continually climb. So for the near future if you are in the early stages of a 4 or 5 year fixed you are still probably looking at the IRD.

  4. Hi Cottager & Naveen,
    Depending on the lender, rates, etc. you could easily pay an IRD charge to break your mortgage early, even if rates go sideways (or slightly up). The odds of this rise if you’re with a major bank.

  5. Re. the above questions, keep in mind that the differential calculation uses rates for a shorter term, so even if rates stay the same the IRD is non-zero (because you are taking the difference between 5-yr and 2-yr rates, for example).

  6. It depends on the lender. For lenders that use discounted rates in their penalties, you probably won’t pay IRD if rates stay the same.

  7. also, some lenders dont use contracted rate but instead use posted rate, check your lenders documents what rate they use as some times it may make a lot of difference and your LTV’s might change if you are adding in the new mortgage

  8. Now on 10 year term fixed rate , on year 5 plus a day – does the IRD still apply or is it a matter of 3 months interest only ?
    I have read previously that the IRD Penalty is removed after year 5 of a ten yr term — is this a rule or policy that is still in play ?
    I dont see it mentioned to often , but would like clarification on this .
    Thanks so much !

  9. Hi Sab, you are correct on the 10 yr.Exept it’s actually legislation that makes this rule. So it applies to all lenders in canada.

  10. Unfortunately not. At least I haven’t seen one. The main thing to remember is that big banks have the worst penalties of all!

  11. Slightly behind on this post…but a well-thought out chain of comments. A tip of the hat to the authors for consistently supplying such valid info in this format.
    Further thoughts to consider are:
    -fixed rates serve a purpose – i.e. long-term cost stability while paying off a massive debt obligation
    -they should not be avoided simply because one is afraid of possibly paying a penalty
    -penalties can be avoided entirely, in most cases, by simply maintaining a relationship with that same lender (there are certainly exceptions to this)
    -discounted broker-oriented lenders typically do not have ‘posted’ rates to choose from, thereby offering a slightly greater degree of clarity when calculating penalties
    -paying a penalty means a financial change of some kind. Odds are good that no-one will run a 10-year fixed term to maturity without a change of some kind (as noted above). A consumer knowing their options PRIOR to entering into that decision is the responsibility of the lender rep, banker, agent or broker providing it. If a client is aware of these things, and the mortgage is validated as part of a long-term debt elimination or financial strategy, the penalty conversation can take place, but end up being irrelevant.

  12. I got a letter from my bank saying that it’s time to renew my mortgage. Could you give me an update on the current mortgage situation, what banks are offering in fixed terms and variables. Thank you so much.

  13. Yes you can often port a mortgage, do a blend or add a new mortgage component without a penalty. I think it’s misleading, however, to say that is true in the majority of cases. It depends entirely on the lender’s policies and the borrower’s circumstances. It is a discussion that all mortgage professionals should have with their borrowers before choosing a lender.

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