Posted Rates & Penalty Pain

THINK OUTSIDE THE BOX:  When choosing between mortgages, knowing how different lenders calculate penalties can be essential.  The market and your needs can easily shift during the term of your mortgage and the last thing you want is a painful penalty in order to get out early.

Penalty formulas differ radically, depending on the lender. A major bank, for example, will have a considerably higher penalty than a broker-only wholesale lender. Advice on how to avoid painful penalties is a key benefit of working with a mortgage broker.

You need to ask one important question right off the bat: What rates does the lender use to calculate its penalty? The actual discounted rates that people pay, or some artificially high posted rate? Hopefully the former.

Below is an example of how two lenders calculate the same “interest rate differential” penalty in different ways. Ask yourself, which one would save you the most money?

Penalty #1 – Broker Lender
Contract Rate (The rate you actually pay) 4.19%
Current Rate (Today’s new rate, closest to your remaining term) 3.09%
Differential (Contract Rate – Current Rate) 1.10%
Remaining Balance $229,000
Remaining Months 16
Penalty Formula: Remaining Balance x Differential ÷ 12 x Remaining Months $3,358.67
Penalty #2 – Major Bank
Contract Rate (The rate you actually pay) 4.19%
Current Posted Rate (Today’s new posted rate, closest to remaining term) 3.39%
Original Posted Rate (At the time you got your mortgage) 5.99%
Original Discount (That you received off the Original Posted Rate) 1.80%
Differential (Contract Rate – (Current Posted Rate – Original Discount)) 2.60%
Remaining Balance $229,000
Remaining Months 16
Penalty Formula: Remaining Balance x Differential ÷ 12 x Remaining Months $7,938.67

As you can see, there can be quite a difference in prepayment charges when you leave a lender early – over $4,500 in this example. And this is a modest hypothetical calculation. Bank discounts today are on the order of 2.00 percentage points off posted, instead of the 1.80 I’ve used here.

Some lenders will even charge an abnormally high penalty (like 3% of principal) despite you being close to the end of your mortgage term. They do this as a retention tool to keep you from leaving. Others will charge a “reinvestment fee” on top of the penalty, tacking on another $100 to $500 in expenses.

In short, penalties can be thousands—or even tens of thousands—higher depending on the lender’s specific calculation formula, mortgage amount, rates and time remaining until maturity. Extreme penalties are not only more expensive, they can even keep borrowers from moving because the amount eats into the money they’ve got for a down payment and closing costs.

Worse yet, some lenders have a “sale only” clause in their mortgages, meaning you can’t even leave them unless you sell the home. If you think, “Oh, that’s no big deal. I don’t plan on selling,” think again. Throughout every path in life, there are moving parts and uncertainties. When you get married, do you plan on divorcing? Likely not. Did you predict the company you were with for 20 years could downsize, or your pension would be reduced or cut? Can you guarantee your health will never throw you a curve ball?

We all want to believe that none of the above scenarios will come to pass, but they can and do. And when they do, what a relief it is to have options.

And last but not least, there is the refinance consideration. If interest rates fall 0.5-0.8%, (which may seem unlikely but is certainly a possibility) there may be opportunities to lower your borrowing costs. But you can’t do that unless you’ve got a low-cost way to renegotiate your existing contract. And as we’ve seen above, that cost is not based on just your interest rate alone.

Canadian Mortgage Trends   April 16, 2015  Guest-Angela Calla, AMP


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