Prepayment charges may apply in various situations, such as when selling your home, refinancing, or making lump sum payments that exceed allowable prepayment privileges.
Types of Penalties:
- Variable Rate Mortgages: Capped at 3 months’ interest.
- Fixed Rate Mortgages: The higher of 3 months’ interest or Interest Rate Differential (IRD).
What is Interest Rate Differential (IRD)?
For example, if you have 3 years left on a 5-year term, the lender compares your rate to their current 3-year rate.
How IRD is Calculated:
- Your Contract Rate: The fixed rate you locked in when you signed your mortgage.
- Current Rate: The lender’s rate for a mortgage term closest to your remaining term.
- Difference: The IRD is calculated based on the difference between these two rates multiplied by your remaining balance and term.
How Banks Calculate IRD:
Banks often use “posted” rates (higher than actual rates offered) in their calculations. This inflates the gap between your contract rate and today’s lower rates, leading to higher penalties. For example, if your contract rate was 3.5% and the posted rate was 5%, the larger difference would result in a much higher penalty.
How Monoline Lenders Calculate IRD:
Monoline lenders, which specialize in mortgages, typically don’t use inflated posted rates. Instead, they use the discounted rate that you were actually offered, meaning the difference between your contract rate and current rate is smaller, leading to much lower penalties compared to banks.
Real-Life Example:
Homeowner took a $400,000 mortgage with a 5-year term at 4.54% 2 years ago. At this time, the bank posted rate was 6.49%. They are looking to refinance now, and current rates are 4.34% for a 3 year term (Their remaining time until maturity).
- Bank IRD Penalty: Difference in rate is 0.2%, plus initial 1.95% ‘discount’ from posted = 2.15%. 2.15% on $382,000 remaining x 36 months = $24,639
- Monoline IRD Penalty: Difference in rate is 0.2%, no extra discount applied. 0.2% on $382,000 remaining x 36 months = $2,292.
- Difference = $22,347
When choosing a lender, it’s crucial to factor in potential prepayment charges. 3-5 years is a long time to plan for, and life events happen that can throw us off course. Protect your home’s equity and your wealth by understanding all of the pros and cons of the options in front of you.
