Painting a Picture of Penalties

Penalty-CalculationsA 1/10th percentage point rate discount on the average Canadian mortgage saves roughly $800 in interest over five years.

An unfavourable mortgage penalty (interest rate differential charge) on a fixed mortgage can cost the same borrower 2-5 times that amount, or more.

By and large, lenders with favourable penalty calculations do a poor job of highlighting their competitive advantage. But ATB Financial is one lender that does it right.

ATB is one of the best lenders at showing how a “fair penalty” works: Example 1, Example 2, Example 3

Its website juxtaposes:

A)  The penalty formula of a major bank:

(Contract rate – [Posted rate for remaining term – Discount from original mortgage]) x Principal outstanding x Remaining term

B)  A “fair penalty” formula:

(Contract rate – Posted rate for remaining term) x Principal outstanding x Remaining term

Note that “Posted rate” in this second formula refers to the actual everyday rate offered to consumers, as opposed to an artifically high posted rate.

Various lenders, including major banks and certain credit unions, use unfavourable penalty formulas.

Conversely, many lenders use a fair penalty calculation like ATB’s above. You just have to know where to find them. Any broker can name several such lenders. (We are also compiling a list of the biggest fair penalty lenders and will post it soon.)

Lenders with reasonable penalties could be well served to follow ATB’s lead and highlight this as a competitive edge on their website. By explaining and quantfying the potential savings, some borrowers are more open to paying a slight rate premium.

Mortgage-Calculations (2)A lender could even create a calculator comparing its penalty versus a major bank’s. The customer could enter his/her mortgage amount with some basic assumptions and the webpage would display a range of hypothetical savings (based on future rates). The potential savings could then be put in terms of an equivalent rate discount.

Despite the fact that a majority of 5-year borrowers renegotiate their mortgage before maturity, only a minority of people actually pay a penalty. Many sidestep penalties by porting their mortgage or doing a blend and increase. But those alternatives have pitfalls (you have to qualify with that lender, you may not get its best rates, and some lenders build a penalty into their blended rate).

Most people who pay penalties never expected that their circumstances would require it. That’s why it’s always helpful to understand (ahead of time) what a lender’s penalty calculation might mean to your bottom line.

Sidebar: ATB says that in the last 12 months, 9% of its 5-year fixed borrowers paid out their mortgage before the maturity date (some might come back under porting). Another 3% renegotiated or changed their mortgage contract, including refinancing and porting.

ATB notes that the numbers given above are fairly dynamic and depend on various factors pertaining to portfolio aging, the interest rate environment, time of year, economic conditions, property values, mortgage type (conventional vs. high ratio), social/demographic changes, etc. These could vary from time period to time period.

Rob McLister, CMT  (email)

  1. Rob…you may have missed that a bank or CU can also chose to “waive” or discount that penalty if you chose to stay with them instead of going with your broker.
    If you complain…they may give some back and make you sign a waiver. Hence, no one gets to sue them. The ones that are still suing have no leg to stand on as the lawyers representing them have no clue why it is so wrong.

  2. Hi th3uglytruth
    It’s true that any lender can choose to discount prepayment charges to keep a customer. Even those with fair penalties do it. But it’s not set policy at most lenders.
    Often when lenders do offer penalty discounts, it equals the amount of the borrower’s unused prepayment privileges (e.g., 10%, 15%, 20%). That seldom offsets the extra cost of a posted-rate penalty.
    Moreover, reduced penalties are not typically a free lunch. The lender will often use its leverage in those cases to charge rates that are higher than what a new customer would receive (and notably higher than those available elsewhere).
    The key here is that “can” and “always will” are different. As a borrower you want assurance, and if something is not in the lender’s charge terms, conditions or disclosures, you can’t rely on it.

  3. great article Rob, as always.
    if you have the information compiled, might you also post the lenders with the LEAST favourable penalty payments alongside those with most favourable?
    just an idea as it works both ways for the consumer.
    thanks again.

  4. there is no such thing as “assurance” from a banker.
    how do you think they were able to change the way they calculated the penalty after market disruption?
    these penalty fee income (that is over and above the old way of calculating it) is PURE GRAVY for these fill in the blanks…

    1. th3uglytruth

      What you said doesn’t make sense. If something is spelled out in a mortgage contract, the bank has an obligation to honour it.

  5. “there is no such thing as “assurance” from a banker”
    Does anyone else hate cynical and absurd generalizations like this?

  6. I heard that Industrial Alliance has an IRD penalty based on bond yields. Does this make it more expensive than IRD penalties at the major banks?

  7. This is a great article. On one of the problems with a data base of all lender prepayment penalties is that they change their policies fairly frequently.
    Another point is that that majority of people do either finish their term or port their mortgages. The majority will not pay any penalty. It becomes a question of proper client communication and disclosure.
    If we do our jobs as brokers we can do a good job for the consumer. That being said, even the client does not know their future for a certainty, all we can do is the best we can do, marriage break-down and long term job loss will destroy the best laid plans.

  8. Skip the Opportunity for Game Playing & Simplify!
    I have always wondered what others thought about using an IRD formula derived solely off bonds using a widely-used technique in other industries called Marked-to-Market.
    Using a 5-year fixed as an example original term: (5-year Canada Bond at origination) less (X-year Canada Bond at Early Termination), where X is the closest years remaining.
    The data is easy to find*, and the implied assumption is that the premium to bond for any particular lender at the point of origination is acceptable at the point of termination. The other assumption (or agreement required) is that the Canada Bond is acceptable as a proxy funding cost for all lenders.
    So if I signed a 5 year fixed at 3.79 and 5 year bond at time was 1.79, the lender premium or spread was 2% at the time, which we hold constant. If I want to terminate today with 26 months remaining, then the 2-year Canada is used (say 1.03%). So IRD is (1.79-1.03)% X 26/12 yields IRD per term remaining X balance. Notice how 3.79% has nothing to do with the math, nor does the lender’s current offering need to be determined. Game-playing is eliminated.
    This method is called “mark-to-market” and is the only acceptable way in most other industries, such as Natural Gas Trading. Agreement on the indicy for fair market price* is the only initial debate as I see it. Thoughts?
    Chris Richards
    Quantus Mortgage Solutions

  9. Your method is cheaper than existing penalties, especially with a flat yield curve. That’s why I don’t think lenders would adopt it.
    The other problem is that it’s not any easier for consumers. The length of the formula doesn’t change. Only the inputs change.
    The Current discounted formula:
    (Contract rate – today’s discounted rate for the remaining term) x Principal outstanding x Remaining term
    The Marked-to-market formula:
    (Bond yield at origination – bond yield today for the remaining term) x Principal outstanding x Remaining term
    You would need a good calculator with a database of historical yields to make this work. Then the challenge becomes explaining to someone how bond yields affect their penalty.
    This is probably an academic discussion regardless since marked-to-market, as you propose it, lowers lender profitability.

  10. How is that Scotia & TD Bank are 1 & 4 in mortgage broker market share as of Q3 ( Broker-lender Market Share ), when mortgage brokers constantly complain about banks charging a punitive penalty to break the mortgage term. If brokers want to make a difference, then dont send the banks mortgages, especially knowing that you are putting clients into a product that has a unfair penalty calculation compared to other Financial Institutions. Is this a case of “Do as I say & not as I Do”

  11. Actually, M-T-M doesn’t change anything with respect to penalty amount: you are simply subtracting two lower numbers so the difference (hence penalty) doesn’t change. The MAIN difference is that the underlying bond rates are easy to find, historical, and are NOT subject to discretion/ manipulation/ confusion, whereas the variables and formulas currently in use are.
    Lenders are well aware of M-T-M and it is used intensively in other parts of their business, especially interest rate and money market management. (Research “ISDA Master Agreement”). In international finance, M-T-M is absolutely part of Generally Accepted Accounting Principles (GAAP) because it is objective and works. Come to think of it, this might be a great horse to ride for CAAMP and consumers…

  12. Great article! Im looking forward to the sequel!
    Im a mortgage broker based in Montreal.
    whenever possible, I refer my clients to First National so they can take advantage of a lesser penalty should they decide to break the contract before the end of their term. First National also has an example of the calculation of the penalty on their website!
    Thank you for posting this, we need more of this around!
    Katy Ramos-Borges

  13. I have never had a bank waive a clients penalty and I have argued this many times and they refuse to do this.
    There are a couple of lenders left that charge the IRD based on the clients current mortgage rate and this is where we should all be putting our clients.
    As for clients able to port & increase ect… this was a option in the past be for the Government changed the rules 2 years ago.
    Now all clients that have a product under a 5 year fixed rate must qualify at the 5 year posted and as you may know not all qualify so they must pay this high ridiculous unfair penalty.

  14. Hi Rob
    I do agree that the payout penalty should not be the defining factor why a mortgage should be chosen. But are Scotia & TD mortgages better products with superior rates than otehr lenders? In this very forum there was the hotly debated article about TD Colateral mortgages? Brokers cant complain about a lender and their practices and then make them #1 & #4 in market share.

  15. RBC represent the worst case in my personal experience with mortgages so far regarding the penalty … I even did change with them on variable. Still had to pay the unfair penalty.
    They don’t get much of my money business anymore though and that’s how it’s going to be for the future too.

  16. …cause you don’t like the truth means EVERYONE doesn’t as well?
    Sensitive aren’t we….the truth must have touched a nerve!

  17. Most don’t get it…
    The ONLY reason why the penalty calc was changed was to PREVENT refi with another FI and easy transfer outs. It is legalized GREED.
    It isn’t complicated. Anyone with a treasury background or common sense can figure out the cost of funds to break a mortgage isn’t what it is souped up to be.
    And the bankers continue to count on brokers who hath no guts to move their clients elsewhere.

  18. I hear you. The fact is, virtually every lender in the country has unfavourable costs or limitations–some much more than others. But it’s the overall value that drives volumes.
    Using Scotia as an example, its broker arm is exceptionally well managed and heavily invested in our channel. It offers:
    * one of the best models in the industry (its business relationship manager model)
    * a wide array of mortgage products (some that brokers can’t get elsewhere)
    * popular product features (notwithstanding concerns about penalty calculations, conversion rates, etc.)
    * pricing that sometimes leads the market on certain terms
    * brand recognition
    * a branch network
    * etc…
    It’s not surprising that Scotia is #1 in our channel.

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