It is very common for people to believe that the rate is the most important consideration when selecting a mortgage product. In many cases, this is a reasonable assumption, many times customer are deciding between mortgage products that are very similar in rate. In this case, as in most, understanding the terms of the mortgage are more important then the interest rate. It is unfortunate that too many Canadians find themselves learning about one of the most important terms which has very negative effect on their financial situation when it’s too late, Payout Penalties.
When calculating a mortgage payout penalty, banks and broker lenders use the greater of:
- A 3 month interest penalty or
- The interest rate differential (I.R.D)
This is where the similarities end. Banks calculate their I.R.D. based on the discount off the posted rate for the nearest term at the time of payout, while the broker lender uses a re-investment rate. The bank discount is the discount you received at the time of approval.
The example that I am using is a mortgage with a balance of $400,000.00 at 2.79% with 26 months left on the original 5 year term. The 2.79% rate from your bank was a 2% discount off the original 5-year posted rate of 4.79%. The broker lender does not deal in posted rates as such.
Interestingly enough, the bank posted rate for the nearest term of 2 years was 3.24%, and the reinvestment rate for the broker lender was also 3.24%.
For the broker lender, the reinvestment rate was higher than the rate on the mortgage paid out, so the 3-month interest penalty is charged. The penalty worked out to $2,790.00.
The bank penalty was calculated using the original 2% discount subtracted from the 3.24% posted rate for a 2 year term. This resulted in the penalty being charged as the difference of 2.79% minus the 1.24% or 1.55% differential for the remaining 26 months of the term. The result was a penalty in the amount of $13,433.33 or a difference of $10,643.33. The banks not only get to charge the higher penalty but also get to reinvest the money at the higher rate. Win, win for the banks but lose, lose for the borrowers.
In the past three years, many Albertans had to sell their homes due to unforeseen circumstances. Do you not think that the $10,000.00plus in penalty differences would have been better in the hands of these Albertans or your hands versus going to the Ivory Towers on Toronto’s Bay Street?
Written by: Dave Melnyk, Mortgage Advisor – Jencor Mortgage Corporation