A mortgage in its simplest form is a contract. It has terms, conditions, rights and obligations for you and the lender. When you sign on the dotted line, you are agreeing to those terms for the length of time laid out in the contract. However, sometimes life throws us an unexpected event that brings around the need to make key decisions and changes. One of these changes, for whichever reason, might be needing/wanting to break your mortgage contract before the end of the term. Can you do that with your existing mortgage? What are the potential financial penalties?
To answer the initial question of can it be done, the answer is “yes” in most cases. Most mortgage lenders will allow this provided they receive compensation. Compensation in one calculation is known as an Interest Rate Differential or IRD. When you started your fixed rate mortgage you had a rate of xx.x%, but the best they can lend to someone else right now is 1% less, so they want the difference. Seems fair, right? However, like most contracts, the fine print tells the true tale. The method in which the IRD is calculated is what borrowers should be aware of.
Example “A” – Posted Rate Method – Generally used by major banks and some credit unions
This method will use the Bank Of Canada 5 year posted rate to arrive at the formula to calculate the penalty. It also considers any discounts you received. These are the ones you will commonly see on their websites or when you first walk into the Bank or Credit Union. Now, rarely does anyone settle on that rate-there is a discount normally that is given. This gives you the actual lending or contract rate. When this method is used, you will be required to pay the greater of 3 months interest or the IRD.
Bank of Canada Posted Rate for a five-year term: 4.89%
You were given a discount of: 2%
Giving you a rate of 2.89% on a five-year fixed term mortgage.
Now you want to exit your contract at the 2-year point, leaving 3 years left. The posted rate for a 3-year term sits at 3.44%. The institution will subtract your discount from the posted 3-year term rate, giving you 1.45%. From there your IRD is calculated like so:
2.89%-1.45% = 1.44% IRD difference x3 years = 4.32% of your mortgage balance.
On a mortgage of $300,000 that gives you a penalty of $12,960.
For most, that is a significant amount that you will be paying. It can equate to thousands and thousands of dollars, depending on the mortgage balance remaining.
Example “B” – Published Rate Method – Generally used by private lenders and most credit unions
This method is more favourable to the borrower as it uses the lender published rates. Generally, these rates are much more in tune with what you will see on lender websites and appear to be much more reasonable.
Your rate: 2.90%
Published rate: 2.60%
Time left on contract: 3 years
Equation for this: 2.90%-2.60% = 0.30% x3 years = 0.90% of your mortgage balance. A much more favourable outcome. On a $300,000 mortgage that would equate to only $2,700.
The above two scenarios operate under the idea that the borrower has good credit, documented income, and a normal residential type property. It is also a fixed rate mortgage, not a variable one. For variable rate mortgages, if the contract needs to be broken, generally the penalty will be a charge of 3 months interest, no IRD applies.
Note: The Interest Act prohibits IRD penalties on terms over 5 years, after five years has elapsed. In such cases, a maximum 3-month interest penalty may apply. For example, someone who has been in a 6-year mortgage for 60 months or more would pay a 3-month interest penalty (maximum) to break it before maturity. The 3-month interest penalty also applies in mortgage scenarios where the borrower may have renewed “after the initial 5 year term” for an additional period.
So, if you do find yourself in a position where you need to end your contract early get in touch with us at Genesis Associates Ltd to review your options.