You’ve decided to risk your lender’s three-month interest penalty and end your mortgage contract early.
Congratulations on finding a lower interest rate online, or saving enough to pay off your mortgage early.
Now tell us why again you’re facing a three-month interest penalty for doing the right thing.
How Mortgage Interest and Penalties Are Calculated
First off, a look at how penalty interest is calculated.
For fixed rate mortgages, you’ll pay either:
- a three-month interest penalty, or
- the interest rate differential (IRD)
for ending a mortgage contract before its term is up.
Lenders charge the three-month interest penalty to discharge a variable rate mortgage early.
They may use your current interest rate, or their prime rate.
Since not all lenders calculate the three-month interest penalty the same way, check your lender’s policy before you cancel your contract. When to break your mortgage contract.
Mortgage tip: Most closed-term mortgages allow you to pay down 10% to 20% of the principal annually. Ask your lender for an open-term mortgage if you expect a windfall or plan to fast track your payments.
Understanding the Interest Rate Differential (IRD)
IRD you say. What’s that?
It works like this:
- Your lender checks your mortgage interest rate. They look at the posted rate on the day you borrowed your mortgage, not the discounted rate your mortgage officer offered you.
- They compare it to today’s posted interest rates.
- If today’s interest rates are lower than when you borrowed your mortgage, your lender charges the difference between the two, instead of a three-month interest penalty.
Your lender uses the IRD to make up for lost profits, interest they would have earned if you paid your mortgage up to the end of term, or they lent that mortgage to someone who did. Mortgage renewal vs refinance.
How to Calculate a Three-Months Interest Penalty
To arrive at the three-months interest penalty, your lender multiplies the remaining mortgage principal by your interest rate, and divides it by 12 months. That gives your lender the monthly interest payment. They multiply the monthly interest by three months, giving you a three-month interest penalty like this:
$500,000 principal at 5.75% with 24 months remaining (3-year fixed term)
$500,000 x 5.75% = $28,750
$28,750 divided by 12 months = $2,395.83
$2,395.83 x 3 months penalty = $7,187.50
Calculating the Interest Rate Differential
The IRD is slightly (!) more complicated. Be aware that how IRDs are calculated depends on your lender’s policies, which is why checking before you break your mortgage is always wise. What a mortgage lawyer does for you.
Your lender checks the interest rate you received compared to the posted interest rate on the day you signed your mortgage. If you got a discounted rate, you lose that advantage. The IRD is based on the posted rate.
Your lender compares your interest rate to today’s posted rate. The posted rate is usually higher than the advertised rate on their website. (There’s that lost discount again.)
Your lender subtracts your posted interest rate from their currently posted rate. They multiply the difference by your remaining principal, and divide by 12 months to get a monthly amount.
The monthly amount is multiplied by the number of months remaining in your mortgage term, and that’s your IRD. What borrowing a CMHC high ratio mortgage will cost you now.
The IRD calculation looks like this:
$500,000 principal at 5.75% interest with 24 months remaining (3-year fixed term)
4.25% lender’s posted rate – 5.9% your posted rate (5.75% + .15% discount) = 1.65%
$500,000 x 1.65% = $8,250
$8,250 divided by 12 months = $687.50
$687.50 x 24 months = $16,500
That’s $9,312.50 more than the three-month interest penalty.
Moral: borrow low, sell high. When to get a portable mortgage.
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Using a licensed real estate lawyer ensures your mortgage documents are in order, and offers to purchase or sell reviewed before you take that all-important step to refinance or buy property in Ontario. While your realtor can help you make an offer, only a licensed lawyer can give you legal advice and you finalize a real estate transaction in Ontario.
Questions to ask a lawyer when buying a house.
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