More than half of all mortgages are on a five-year term. That is because a five-year fixed-rate mortgage is an ideal investment for a bank. It’s the longest period they can lock borrowers in, while still charging a substantial penalty if borrowers choose to break their contract.
But a lot can happen in five years, In fact, 70% of borrowers refinance their loans before their terms are over.
Why this matters
Consider these three scenarios:
- Marianne’s marriage has just ended and she needs to break her mortgage to sell her house.
- Danielle, is pregnant and would like refinance to do some costly home renovations. And a third individual,
- Tony, has found a mortgage with a lower interest rate, and would like to switch lenders.
Unfortunately, neither Marianne, Danielle, nor Tony compared penalties for breaking a mortgage contract when they were shopping around. They found the penalties for breaking a mortgage contract unclear, and thus none of them factored possible penalties into their original purchasing decision.
Marianne, Danielle, Tony—and you, if you need to break your mortgage—will have to pay a penalty of whichever number is higher: three months interest on their mortgage, or the Interest Rate Differential (IRD).
The IRD is a calculation of the interest a financial institution would lose if it were lending the funds at today’s rates. To determine an IRD, the lender will compare the rate the homeowner is paying to the current rate of a similar product being sold. The lender will also factor in the length of time remaining in the mortgage as well as the money still owed (outstanding principal) in the mortgage.
It sounds complicated because it is
Different lenders integrate or emphasize different factors to calculate the IRD, which means they can make the calculation work heavily in their favour.
In the third scenario, when Tony originally purchased his mortgage, his bank offered a discount off the posted rate. But when it comes to calculating the IRD penalty, banks can use the posted rate—not the discounted rate.
In other words, banks may choose to entice you with a discounted rate, but can opt for the posted rate when it’s in their favour, making the penalty for switching lenders much higher.
How to protect yourself
Consider the penalties for breaking a mortgage when shopping for one. Many borrowers, or potential borrowers, do not know the amount they would be expected to pay to break their mortgage early. And it’s an important number, whether your need to know is caused by financing possibilities, or because life sometimes throws a curveball.
Luckily, an increasing number of third-party penalty calculators are available on the Internet. These can provide you with some insight on the penalties you could accrue if you wanted to break your existing mortgage.
Better yet, why not start out with someone on your side, who will make you aware of the potential penalties from a lender.
A mortgage broker will help you look beyond a lender’s deceptively appealing low rate, and consider all the factors, including potentially ruinous penalties.