Penalties for Early Repayment (Prepayment)

 
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When you pay off any mortgage early there can be fees and penalties. First we will describe the penalties because these are usually higher, and then we will look at the range of fees lenders charge for paying off your mortgage.

It is difficult to predict life events. Typical events like having a child, getting a job offer you can’t refuse, or a relationship split can lead you to sell you home sooner than expected and cancel your mortgage.

People focus so much on the up-front rates when comparing mortgage offers that they sometimes get caught by back-end penalties and fees.

Penalties

If you pay off a closed-term mortgage early (i.e., exceed the limits of your early repayment privileges) you will get charged a penalty. The penalty will be laid out in the mortgage agreement.
There are 2 ways of calculating the penalty and the borrower is always charged the bigger of the two.

  • 3 months of interest
  • Interest rate spread (interest rate differential)

3 Months Interest

3 months interest is simple to calculate. The only tricky party is converting the mortgage interest rate from compound semi-annual to annual when doing the calculation for a fixed rate mortgage.

Let’s take the example of a $400,000 mortgage at a rate of 5.00% compounded semi-annually.

Step 1: Convert compound semi-annual rate (CSR) to simple annual percentage rate (APR).

 

 
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To do the math yourself, use the equation above. The simple annual percentage rate (APR) is 5.06%.

It is common industry practice to quote rates as compounded semi-annually because it makes the rate look a little lower and charging an extra few 0.01% on every Canadian mortgage adds up to a lot of profit for lenders.

Step 2: Calculate 3 months worth of interest.

 

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Interest Rate Spread

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Interest Rate Spread, also known as Interest Rate Differential (IRD), only applies to fixed rate mortgages and is much more complicated. On the day that you pay off the mortgage, the IRD is the difference between the interest rate on your mortgage with the lender and their latest posted rate for a mortgage with a term similar to the time remaining on your contractual term, BUT there are three ways of calculating this penalty.

People focus so much on the up-front rates when comparing mortgage offers that they sometimes get caught by back-end penalties and fees.

Sample Interest Rate Spread Calculations

In January  2017, Jim and Nancy get a 5-year locked-in rate mortgage with the following characteristics:

5-year Fixed Posted Rate:

6%

5-year Fixed Negotiated Contract Rate:

5%

Negotiated Interest Rate Discount

1%

Mortgage Amount:

$406,000

Mortgage Lifespan:

30 years

It is now January 2018 and Nancy has got a promotion at work that will transfer her to Toronto so they need to sell their condo. There are 4 years remaining on the mortgage contract and the 4-year posted mortgage rate is 4%. What is the interest rate spread penalty?

 

 Standard
IRD Penalty 

Discounted
IRD Penalty1

Posted
IRD Penalty

Remaining Mortgage Balance  $400,000  $1,500  $1,240
2017 Comparison 5-year Rate 5% contract 5% contract 6% posted
2018 Comparison 4-year Rate 4% posted 3%2 4% posted
Penalty Charged $4,090 $8,160 $8,200

1. Most of the 7 largest banks in Canada use the discounted IRDc calculation.

2. 4% posted minus the 1% discount negaotiated back in 2017.

There is a big difference between these numbers. Imagine Nancy spent weeks negotiating and extra 0.1% off of the mortgage rate (a savings of approx. $1,975 over 5 years) but she doesn’t know that the lender offered the better rate because they use a higher penalty calculation and 30% people have to break their mortgage and pay a penalty.
When Nancy breaks the mortgage after 1 year to take a great job in Toronto then she will only gain $400 from the extra rate discount but will pay $8,000 in penalties to break the mortgage. In that scenario She loses $7,600 for focusing too much on rate.

Fees

In addition to penalties for Early Repayment, there are also fees. Many of these fees are simply fees for paying off your mortgage whether you break the contract or not, but since these fees can be substantial they are worth considering when making the final lender choice.
I took the liberty of inspecting the “cost of borrowing disclosures” from 5 lenders to illustrate the range of fees. These disclosures are often provided at the lawyer's office (after you’ve passed the point of no return).

Fee/Charge

Lender 1

Lender 2

Lender 3

Lender 4

Lender 5

Discharge (B.C.)

$75

$75

$75

$75

$75

Transfer to other Lender

$365

$200

$260

$250

$75

Reinvestment Fee

(if contract broken within 3 years)

$500 w/in 1 yr

$400 w/in 2 yrs

$300 w/in 3 yrs

-

$300

n/a

-

Discharge Registration Fee

-

-

$35

$29

-

Early Renewal

$75

-

-

-

$200

IRD Calculation

Standard

Discounted

Discounted

Discounted

Standard

As at February 22, 2018

There are 7 large Canadian Banks, hundreds of credit unions, and dozens of other large mortgage lenders across Canada it is unrealistic for consumers to research all of this information, and people in the branch only know their own fees and that is another reason why we recommend Mortgage Brokers.

Penalty Reduction Strategy

You can significantly reduce your early repayment penalties by first making an allowable early repayment of 10% to 20% of the original balance 15 to 30 days prior to the final pay-off. This strategy will reduce your penalty.

To do it, you will have to take cash out of your savings or or borrow from a line of credit.

 

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