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Understanding mortgage pre-payment is one of the most overlooked aspects of many homebuyers due to the fixation with the contract rate. The bank end exit of a mortgage on sale should be equally considered as the front end.
In Canada, mortgages that do not have a prepayment penalty are known as “open,” while those that charge you for paying the note off ahead of time are “closed.” The interest rate on closed mortgages is generally lower than open ones. If you do have a closed mortgage and pay it off early, the penalty is known as the IRD, or interest rate differential. In some cases, the contract may have some prepayment privileges, but if you pay further ahead of time than those privileges permit, then you can still end up with an IRD fee.
The amount of the penalty depends on two factors: the amount that you want to prepay, and the interest rate that is the difference between the rate on your original mortgage and what the lender could charge if he were lending those funds out today over the remaining mortgage term. In most cases, closed fixed-rate mortgages come with a prepayment penalty that is the higher of the IRD or three months’ interest. If yours is a variable-rate mortgage, you generally don’t have an IRD penalty.
Mortgage Prepayment Calculations
UNDERSTANDING YOUR PRE-PAYMENT
Let’s say that you have a remaining mortgage balance of $300,000. The interest rate that you’re currently paying is 3.19 percent and no rate discount was provided at the time you obtained. You have 18 months to go on your note, and if the lender were putting that loan out today, they could get a rate of 2.99 percent. The 3-month interest penalty would be $2,393, while the IRD would be $900. In this case, the pre-payment would be 3 months’ interest of $2,393… the greater of the 2. Now, take a similar situation with the only difference being that the 3.19 percent rate provided was discounted from 4.69% and the bank uses the pre-discount rate to determine their IRD Penalty. Due to the 1.50% discount, the IRD would change to $7650. The 3 months’ interest will still remain the same, however the big difference is the pre-payment penalty is $7650.
There are some other things to consider, though. Each lender can use its own formula for deriving the exact amount of the penalty, so if you sign a closed mortgage but anticipate that you might be able to prepay, you’ll want to know what that formula is. It’s kind of like the way that mortgage lenders look at credit scores differently than consumer reporting agencies do, which is why a lender can come back and say that your credit score is different than what you get when you track it on a website such as FreeScore.com. Lenders have some pretty wide leeway in this sort of matter. However, if you got a discount on your initial rate, some lenders don’t add that in with their own calculation, which can reduce the penalty you would pay significantly. Some lenders round up to the nearest term, while others round down, when finding the comparison rate. Also, if your loan had a term longer than five years, and you’ve been paying on that note for more than five years, the Interest Act keeps banks from levying IRD penalties, so the three-month interest payment is all you would face.
Be careful, though, because there are some lenders that never permit ending a mortgage early, no matter what the penalty would be, unless an approved sale of the property has taken place. This is another reason to know the exact policies and penalty calculation methods for your lender before you sign the paperwork. In actuality, now is a good time for borrowers who want to know exactly what the costs would be in that scenario. The Canadian Department of Finance has established an ostensibly voluntary Code of Conduct that makes banks post explanations of the way they calculate prepayment charges written in understandable English. They also have to provide online calculators so that borrowers can perform their own estimates and make an informed decision on the basis of the results. Such lenders as the Bank of Montreal, ING Direct, National Bank of Canada, Royal Bank, HSBC, CIBC, Laurentian Bank, Manulife Bank, TD Canada Trust and Scotiabank have all agreed to provide this information for consumers, which is a win for the borrowing public, which have had to grope around in the dark for these answers historically.
So how would this work with private lenders? There is a lot less regulation in this section of the mortgage market, which means that private lenders have more leeway. If you think you’ll be able to prepay your private mortgage, you’ll want to get the terms in writing ahead of time. With a closed private mortgage, the most common penalty is three months’ interest. Some private lenders offer open mortgages, but at a higher interest rate. If you’re working with a private lender or a bank, and the property has gone into foreclosure, the good news is that most banks don’t charge prepayment at that time because they’re eager to get their money back.
If you have more questions about your own loan, call us at Amansad Financial, and one of our lending specialists will discuss your situation and go over potential penalties for prepayment.