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Mortgage breakage costs: let's stop the nonsense

Have you ever wondered why the banks list posted mortgage rates that are ridiculously high?

One reason is that it could result in you paying $10,000 or more in extra penalties should you ever break your mortgage with them.

Here is the scenario:

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Many people have, at one time or another, looked at breaking their mortgage in order to get a better rate.

With interest rates dropping to historic lows, it is more and more common for homeowners to think about the benefits of breaking their mortgage, paying a penalty, and locking in to a new lower rate mortgage.

Traditionally, the mortgage penalty on fixed rates is either three months interest or something called the Interest Rate Differential (IRD) - whichever is higher. On a closed, variable rate mortgage, it is usually simply three months interest.

While the three months interest is pretty easy to understand, the IRD is a little mysterious. For help on this, I went to TD Bank's mortgage website. RBC has a similar section.

They both show the following formula:

Step 1: (A)

The current interest rate under your Mortgage expressed as a decimal (for example, 6.75% = .0675)

Step 2: (B)

The current interest rate that we can now charge for a mortgage term offered by us with the term closest to your remaining term. The interest rate will be our posted interest rate for the term minus the most recent discount you received

Step 3: (C)

A - B = C, which is the difference between your current interest rate and the interest rate in B above (write C as a decimal)

Step 4: (D)

Amount you want to prepay

Step 5: (E)

Number of months for the remaining term of your Mortgage

Step 6: (F)

(C x D x E) ÷ 12 = F, F is your estimated Interest Rate Differential Amount

Let's say you have a mortgage at 4.75 per cent, and it comes due in two years, and it has a current principal owing of $400,000. TD's current two-year posted rate is 4.1 per cent. Let's say that you were offered a 0.5-per-cent discount off the two-year rate. The math would work as follows:

.0475 (A) - .0385 (B) = .009 (C)

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.009 (C) * $400,000 (D) * 24 (E) / 12 = $7,200 (F)

While $7,200 seems like a lot of money, if you can lock in a five-year mortgage today at 4 per cent, you are benefiting from two years of a 4-per-cent interest rate instead of 4.75 per cent, but you are also guaranteeing three additional years at 4 per cent, when it is quite likely that in two years, a five-year fixed mortgage rate will be a lot higher.

Here comes the evil part.

At many big banks, they don't use your existing 4.75-per-cent rate. What they do is take the posted rate at the time you took out your mortgage. This is a rate that has no relevance to you, as you never paid it. In fact, it likely isn't listed anywhere on your mortgage contract. Remember the ridiculously high mortgage rate we talked about at the beginning of this article? Now you see what it can be used for.

Is it a good time to lock in your mortgage rate or are variable-rate mortgages the way to go?

If we take the same IRD formula, but replace the actual rate of 4.75 per cent with a posted rate of 6.25 per cent, the IRD becomes:

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.0625 (A) - .0385 (B) = .024 (C)

.024 (C) * $400,000 (D) * 24 (E) / 12 = $19,200 (F)

Because of this sleight of hand, you would now owe the bank an additional $12,000!

If you try and fight the calculation, you will likely face a long line of staff who don't understand the calculation themselves. A few months of complaining through the right channels might get you your money back.

More on mortgages:

  • Video: Variable or fixed?
  • Housing affordability: the great quandary
  • Common mistake: Too much real estate debt
  • Q&A: Variable rate vs. fixed rate mortgages
  • Deciding on a mortgage

In the March budget, the federal government said it would "bring forward regulations" to standardize the calculation and disclosure of mortgage pre-payment penalties. (This applies to federally regulated lenders.) We are still waiting.

This is exactly the type of situation a good financial adviser can help you avoid or manage. The situation on IRD calculations as it currently stands with the big banks is rotten to the core.

Ted Rechtshaffen's Adviser Secrets series:

  • Part 6: Do you want to protect your lender or your family?
  • Part 7: You can be too rich
  • Part 8: Your company pension plan: Demand a great deal
  • Part 9: How taxes affect your financial health
  • Part 10: How much can you afford to give?

Ted Rechtshaffen is president and CEO of TriDelta Financial Partners, a firm that provides independent financial planning advice. He was vice-president of business strategy at a major Canadian brokerage firm and found that the interests of the client were often not aligned with the interests of the adviser or the interests of the company.

This is part of a series that looks inside the financial services industry at what advisers tell their clients and - more importantly - what they don't.

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