In the current environment with interest rates falling homeowners should remember to examine the lender’s prepayment formula before agreeing to any mortgage contract. We all wish life was fully predictable but when a life changing event occurs, you’ll be glad you planned ahead.
Why you may ask?
If you need to break your mortgage early because of health issues, a divorce or an urgent need for cash it will come as a surprise that the default 3 month interest or interest differential penalty, whichever is higher, will not be what the bank demands.
Logically, you’d expect the penalty to be the bank’s current posted rate less the rate you currently pay (i.e. the discounted contract rate you received as inducement to sign with them originally). Unless Aristotle owns your bank though, logic doesn’t apply and you’re in for a shock.
The discounted rate you receive when you sign your original mortgage is not the rate the bank will use to calculate your interest differential penalty. The Bank takes the discount you received off their original posted rate. It then subtracts it from today’s posted rate and compares that against your actual contract rate.
Okay, that’s complicated. Here’s a simple example that will illustrate the inequity.
You originally receive a 2% discount on you mortgage from the bank’s posted rate on a 5-year fixed rate $700,000 mortgage. Then you are forced to break the mortgage the very next day. To be clear you have borrowed their money for one solitary day.
The bank will charge an interest differential penalty of 2%. Which is essentially the previously noted calculation assuming rates are the same as the day before – admittedly a big ask! On the entire amount for the full 5 years. That’s a whopping charge of $35,000 for one day’s work. This is true even though these penalties are supposed to reflect on the bank’s losses because of your prepayment.
Ironically the more of a “deal” you got up front on your mortgage, the worse it becomes.
Let’s put this all in perspective. Take the mortgage described before. If the original posted rate was 5% with the discount your contract rate would be 3%. Assuming your mortgage didn’t require you to pay off any principal, the bank would be entitled to earn approximately $105,000 over the 5-year period. So, on the second day, by their calculation, you’d owe $35,000 for the first day and $70,000 for the remaining 4 years and 364 days. Go figure.
But we already know life isn’t always fair! So how do you fix this? Here are my 3 tips.
- This is the most important: Seek out lenders with fair penalties if you want more flexibility. They exist and they don’t include any big banks. A broker can give you a list but sample names include; Manulife Bank, First National, MCAP, Merix Financial and RFA Bank.
- Read the fine print and always consider your lender’s prepayment formula before refinancing. This is where a seasoned mortgage broker really earns their keep.
- If you need to break your mortgage contract, ask for a payout statement as soon as possible to lock in the penalty. This is crucially important in a falling rate market.
If you have any questions or would like more information please feel free to reach out. I’m here and always happy to help!