As the housing market thaws from a cold winter, mortgage rate specials are popping up like spring flowers. But even as they compete to offer rock-bottom rates, banks have largely kept their posted mortgage rates unchanged.
Few borrowers give posted rates a second glance, since they'll rarely be paying the actual sticker price on a mortgage.
But those posted rates aren't just for show. They play an important – and profitable – role in the mortgage businesses of Canada's major banks, one that many borrowers ignore at their peril when they go shopping for the lowest rates.
First, posted rates matter for borrowers seeking a variable rate mortgage. The federal government views variable rate mortgages as more risky and it has sought to limit their growth by requiring borrowers to meet the qualifying standards for the higher posted fixed rate. (For instance, posted five-year mortgages currently average 4.75 per cent, while banks are offering variable rates as low as 2.20 per cent).
Meanwhile, fixed-rate borrowers can qualify based on the actual rate they'll be paying, which is almost always much lower than the posted rate.
Usually, that means borrowers can qualify for much more money than if they applied for a variable rate mortgage. As a result, the majority of borrowers opt for fixed-rate loans. That works for lenders since they generally make more money off of fixed-rated mortgages.
More importantly, banks use posted rates to calculate fees for borrowers who break their fixed mortgages early.
When interest rates are rising, banks typically charge a penalty that works out to three months' worth of interest payments on a mortgage. But when rates are falling, and when people are more likely to try to get out of their mortgage, banks often base their penalties on something called an "interest-rate differential."
Each bank calculates this slightly differently, but it usually involves the difference between the posted rate on a mortgage at the time borrowers signed the contract and the posted rate on an equivalent mortgage at the time they cancel. Some banks also add in the discount borrowers are actually getting off the posted rates.
In most cases, a penalty based on an interest-rate differential can be tens of thousands of dollars higher than a penalty based on three months' interest. (The penalty to break a variable rate mortgage is based on the three months' of interest payments).
There is a logic behind the interest-rate differential. When borrowers break their mortgages earlier to take advantage of falling rates, banks lose the profits they would have made off the mortgage, since they must now lend out the money to a new borrower at a lower rate.
However, the practice has raised the ire of many borrowers and brokers, who object to banks calculating these penalties based on posted mortgage rates rather than rates that homeowners are actually paying. It is also the main reason why prepayment penalties haven't shrunk even though mortgage rates have come down.
Take Brian, for example. With three years and $520,000 left on his five-year mortgage, Brian (who didn't want his last name used) is getting ready to sell his Vancouver home in order to downsize. He's now facing nearly $30,000 in fees to break his mortgage early, a calculation based on the difference between the 5.24 per cent posted rate on his mortgage when he first signed it two years ago and the 3.39 per cent posted rate his bank is offering today on a three-year mortgage (because Brian has three years left on his mortgage.) The bank uses these numbers despite the fact that Brian's actual mortgage rate is just 2.79 per cent. Had the penalty been based on three months' of interest payments, it would have been around $3,627.
Brian was prepared to pay some kind of penalty for breaking his mortgage early, but expected it would have been one based on the rate he is actually paying and not the posted rate. "The idea is sound. I'm even OK with how the calculations are done," he said in an e-mail. "It's just they use numbers completely unrelated to my actual commitment."