In my last post we discussed the not so friendly IRD penalty. One of the reasons why this mortgage penalty is not friendly is the difficulty in trying to figure out how lenders calculate it.
Most mortgage lenders will simply have this calculation built into their mortgage software and the system spits out a number. Typically the person that you will be speaking with will not know, or be able to tell you, the factors to calculate the penalty manually. At least this has been my experience.
The other thing to consider is that the penalty will change with time and with any changes to the current interest rates. The main components that make up the IRD penalty calculation is your mortgage balance, the time remaining on your term, your mortgage interest rate and the comparison interest rate.
Remember in its simplest form the IRD is the difference between the interest rate on your mortgage contract compared to the rate at which the lending institution can re-lend the money.
Here is a rough way to calculate the penalty.
Lets say your mortgage balance is $200,000 at 5.75%, you have 3 years remaining and the current 3 year rate is 3.75%. Your lender is likely to charge you $200,000 x 36 months x 2% (5.75%-3.75%) = $12,000
If we look at the components in the calculation all are know by most borrowers except for the comparison interest rate. Most borrower will know their balance, time remaining on term, and their current rate. So the big question is what is the comparison rate?
The Comparison Rate can be as simple as the current posted rate for the term that most closely matches your remaining term. However, I have seen some banks use a discount from the posted rate based on your negotiated a discount on your current mortgage rate when you set up your mortgage. This will further increase your penalty when being calculated.
It should be noted that the Interest Act prohibits IRD penalties on mortgage terms over 5 years, after five years has passed a maximum penalty of 3-month interest would apply.
With the recent decline in mortgage rates, and more people reviewing their “keep or break” mortgage analysis, there has been increased pressure to have mortgage penalties more closely regulated and standardized calculations.