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Decoding the mortgage market

Ten questions to help you avoid mortgage-penalty shock Add to ...

Figuring out the penalty on a fixed-rate mortgage is like solving a calculus equation. Homeowners who try often wind up hitting their head against hard objects in frustration.

It’s been that way for years, and as many unwittingly discover, mortgage penalties can be disturbingly expensive.

Historically, lenders have used cryptic penalty language that disguises just how expensive. As a result, folks trying to break their mortgage are routinely shocked and disappointed by four- or five-figure penalty quotes.

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Interest rate differential (IRD) charges, commonly called “penalties,” have long been the biggest culprit. IRD charges compensate a lender for lost interest when you prepay large portions of a closed mortgage early. They’re basically the difference between the interest you promised to pay and what the lender can earn today on a mortgage of your size. Without a computer, even most lender reps cannot calculate IRD penalties with precision.

The biggest penalty I ever saw was $99,000 on a multimillion-dollar property. The average is far less than that – in the four-digit range – but for a homeowner with little discretionary income, it might as well be $99,000.

But things are changing for the better. As of this month, the Department of Finance has convinced banks to peel back a layer of opacity. Most banks now agree to a “voluntary” Code of Conduct that requires them to post plain-English explanations of prepayment charge calculations and provide website calculators so people can run their own penalty estimates.

That latter development is a colossal win for mortgage consumers.

Here, for example, are links to the top 10 banks’ penalty calculators: Bank of Montreal, CIBC, HSBC, ING Direct, Laurentian Bank, National Bank of Canada, Manulife Bank, Royal Bank, Scotiabank, and TD Canada Trust

As helpful as these calculators are, there’s one essential piece of the puzzle that most still don’t provide: the discount you received at the time you got your mortgage.

This discount is key for determining your IRD penalty with the major banks. They could easily permit estimation of discounts online (using their historical posted rates), but omitting this data forces you to call in and listen to their sales pitch to retain your business before you can switch lenders.

Another problem is that few non-bank lenders have taken the initiative to create online penalty calculators. That makes comparing penalties between banks and non-bank lenders unnecessarily difficult, which incidentally plays right into the big banks’ hands.

The majority of long-term fixed-rate mortgage holders terminate or change their mortgage before their term is up. In fact, the average five-year mortgage lasts only three to four years. Penalties apply in only a minority of these cases, but for those who are affected, they can substantially raise your overall borrowing costs

It therefore pays to guesstimate mortgage breakage costs in advance and avoid surprises later. In doing so, you’ll often find that a lender’s bargain interest rate is offset by its harsh penalty.

Before settling on a lender, try this. If you want a five-year fixed term, have your mortgage adviser estimate that lender’s penalty as if you planned to break the mortgage after 3.5 years (the average breakage), assuming rates stay the same. Then ask the adviser to give you a sense for how this penalty would compare to the “typical” lender.

While you’re at it, here are 10 more questions to ask a lender about its penalty:

1. Is your fixed-rate mortgage penalty based on posted rates, bond yields or discounted rates?

The logic: Some lenders – including the Big Six banks – base penalties on posted rates, which can drastically inflate your penalty. Other lenders use bond yields, which can also cost you a small fortune, depending on bond performance. A few are even bold enough to use posted rates when calculating simple “three-month interest” penalties.

2. If I break the mortgage and stay with you, will you forgive a percentage of my penalty or apply unused prepayment privileges, to reduce my penalty?

The logic: More lenders are doing this as competition grows.

3. If not, can I make a prepayment a few weeks before breaking my mortgage to lower the balance used to calculate my penalty?

The logic: When determining a penalty, some lenders refuse to consider prepayments 30-90 days before you request discharge.

4. What term do you use to calculate the nearest comparison rate for an IRD penalty?

The logic: Some lenders use a shorter term than the nearest term, which can significantly increase your prepayment costs.

5. Can I increase my mortgage without a penalty?

The logic: This is important if you ever upgrade your home or need additional funds.

6. If I sell my home and port my mortgage to a new property, how long can I take to close on that new property and still avoid a penalty?

The logic: Some lenders unreasonably require you to close your old and new home on the same day.

7. If I break the mortgage early, do I have to pay “reinvestment fees” on top of the penalty, or pay back any cash incentives that I’ve received?

The logic: Other things equal, why pay a reinvestment fee on top of your penalty? The latter answer is usually “yes.”

8. Can I get out of my fixed mortgage early if I pay a penalty?

The logic: Some “low frills” closed mortgages don’t let you out before maturity – no matter what – unless you sell your home.

9. Do you charge IRD penalties on your variable-rate mortgage, as opposed to the standard three-month interest?

The logic: Despite being highly unorthodox, a few lenders actually do this and it can cost you.

10. How long will you honour your IRD penalty quote?

The logic: This is relevant if you’re trying to discharge a fixed-rate mortgage while rates are dropping. Falling rates can increase your IRD penalty.

Penalties are a realm where borrowers need knowledgeable advice. Sadly, many advisers are inexperienced with penalty calculations and give you a blank stare when you ask too many questions. (That’s a good clue that you should deal with someone else.)

Fortunately, the Financial Consumer Agency of Canada is doing a noble job encouraging clarity with mortgage penalties. By March 5 of next year, it will go a step further by requiring banks to provide: annual information to help consumers calculate their penalty, written penalty statements upon request with clear calculation explanations, and access to exact prepayment penalty quotes by phone.

These initiatives will encourage fairer penalties and help homeowners minimize them, saving many individual Canadians thousands over time.

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