This article has been updated from a previous version.
Fixed-rate mortgages — particularly, the five-year fixed-rate mortgage — have long been Canada’s most popular mortgage type, especially among younger and first-time homebuyers.
Locking in a rate means you’ll always know how much interest you’re paying each month without having to keep your eye on fluctuating rates. However, fixed-rate mortgages do come with one major downside. If you need to break your contract — whether because you’re paying your mortgage off early, wanting to take advantage of lower rates, or selling your home — you might be hit with a heftier penalty than variable-rate mortgage holders would face.
Breaking a variable-rate mortgage usually comes with a straightforward three-month interest rate penalty. Fixed-rate mortgage holders, however, don’t get off so easily: They’ll pay a penalty of either three months’ interest on their current mortgage principal or what’s called an interest rate differential (IRD) fee — whichever is greater.
Here’s a breakdown of everything you need to know about the IRD and what it might mean for you.
What is an interest rate differential (IRD)?
An IRD fee represents the interest your lender would lose out on if it stopped lending to you at your contract rate and instead lent to you at today’s rate.
“It’s essentially a tool lenders use to help compensate them for the loss in profit from a customer,” says Joe Bladek, an Ontario-based mortgage broker.
“And because the customer has broken the mortgage early, [the lender] needs to make up for that.” Fixed-rate mortgage holders are much more likely to face the IRD —and a substantial one at that — if they choose to break their mortgage in a low-interest rate environment. That’s because when interest rates are low, the gap between your contract rate and the current rate is wider. (Variable-rate mortgages tend to be more attractive because they fluctuate with the Bank of Canada’s interest rate moves.)
However, in the current high-interest rate environment, the preference gap between fixed- and variable-rate mortgages seems to be lessening, with fixed-rate becoming more popular among homebuyers.
How is the IRD calculated?
The way your lender calculates it could change the penalty by thousands of dollars. Some lenders calculate the fee by determining the difference between the lender’s current mortgage rate that most closely matches your remaining term and your original mortgage rate, multiplying the difference by your remaining principal, and then dividing that number by 12 months.
The resulting monthly fee is then multiplied by the number of months remaining in your term, giving you the IRD.
For example, say you decide to break your mortgage with 36 months (or three years) left in your term, and your mortgage balance is $400,000. Your original or contract mortgage rate was 4.79%, and your lender's current three-year fixed mortgage rate is 2.39%.
The IRD calculation would look like this:
2.4% (the difference between 4.79% and 2.39%) x $400,000, divided by 12 months x 36 months = $28,800.
But that's not the only way the fee is calculated. Some lenders may choose to incorporate any discount you may have received on the five-year posted rate when you initially signed your mortgage contract. In this case, the lender subtracts the discount you received from the current interest rate that most closely matches your remaining term, and then subtracts that amount from your contract rate before performing the rest of the calculation (multiplying the difference by your remaining principal, dividing that number by 12, and then multiplying that monthly fee by the number of months remaining in your term).
“The discount offered by the lender provides a substantial cushion to that lender on the penalty,” Bladek says.
Calculating a hypothetical IRD on his own mortgage, Bladek saw a $4,000 penalty using the basic calculation, and an $18,000 hit using the discount method.
How to minimize or avoid the IRD when breaking a fixed-rate mortgage
While IRD fees are hard to avoid if you’re set on breaking your mortgage early, Bladek has a few pieces of advice to help homeowners minimize their fee.
First, he notes that some lenders offer a fixed percentage penalty instead of charging the IRD or three months’ interest, which could be more advantageous.
He also encourages homebuyers to look to monoline lenders (lenders that offer only mortgages), which tend to have a lower IRD calculation because they only use the current mortgage rate, rather than including the discount.
If you’re locked into a fixed-rate mortgage that you plan to break soon, you can take advantage of your contract’s prepayment options to lower your mortgage principal and, therefore, your penalty.
While it won’t get you the absolute best rate on the market, signing up for a blended mortgage allows you to lower your rate without a penalty. Blended mortgages combine the existing mortgage rate with a new one to arrive at an in-between rate. These mortgages can be extended for the length of a new term, or last until the end of your current term. And because you’re “keeping” your existing rate, you circumvent the IRD.
Of course, another way to avoid the IRD is to just wait until your mortgage is up for renewal. Ending your contract at renewal will exempt you from the penalty because you wouldn’t be breaking your contract early.
Lastly, if none of these options are possible, or you're caught in extenuating circumstances, Bladek points out that the squeaky wheel often gets the grease. “If you have a problem, call the lender — especially if you have a unique situation.”
“Some people get into a situation that’s out of their control. Maybe it’s a divorce or a death in the family. There can be compassionate reasons that a lender could look favourably upon,” he says.
And in all cases, make sure you’re saving the most amount of money that you can early by shopping around with different lenders before you buy and closely review how each lender calculates their IRD fee. This one step of due diligence could save you thousands of dollars in the long run.