Chances are, at some point in your life it’ll happen. For whatever reason you’ll be looking to sell your house and be forced to break the mortgage early.
We’ve all heard the horror stories about how that can cost tens of thousands in fees. How exactly is that legal? And more importantly, how do you make sure that you get enough flexibility to ensure you’re not paying those huge penalties?
By understanding the basics of mortgage penalties, you’ll be able to at least anticipate them, which is half the battle.
Essentially, the bank doesn’t want you to do anything except pay the monthly amount which was agreed to in the original mortgage. That’s how they make the most money with the least amount of effort. Nobody has to do anything.
But lenders know this isn’t realistic for most borrowers. There are very few mortgages that aren’t adjusted in some way at some point in time. And when it comes to changes, having a borrower pay down a mortgage faster isn’t the end of the world. With every extra payment a borrower owes less, becoming more secure.
This is why most mortgages allow a borrower to pay up to 20% of the original mortgage balance without a penalty each year. It’s in both the borrower’s and the lender’s interest to pay down the loan faster than needed, albeit for slightly different reasons.
Where things get tricky is when a borrower wants to make a huge prepayment, usually because of the sale of the property.
From the bank’s perspective, a sale is a bad thing. Not only have they lost the chance to earn interest on the money lent out, but they’re also paying interest on the money they’ve borrowed to lend out to that homeowner.
Most banks have two sources for mortgage financing. They either use money already deposited in the bank (i.e. GICs), or they borrow the money from investors. Both of those options cost the bank money in interest. By taking that money and lending it to someone at a higher rate of interest, the lender makes money.
This is all fine and good, until the loan disappears. If interest rates have been steady, it’s not a big deal to just take the money from the borrower and use it on the next mortgage that comes along. But in a scenario where mortgage rates have declined, the lender is upset to lose that business. They’d rather lend that money out at 5% compared to 3%.
This is why there are two types of mortgage penalties. On most mortgage contracts, a borrower will either pay out a 3-month interest penalty or the interest rate differential, whichever is higher.
Canadians got used to paying the 3-month interest penalty because rates were consistent. In that sort of environment the lender can charge the next borrower about the same amount, so the penalty charged to the borrower was minimal.
Where things get complicated is with the interest rate differential. Essentially, the lender wants to get compensated for the missed opportunity to lend at higher rates, so they make the borrower come up with the difference.
Say you bought a house 3 years ago, taking out a 5-year fixed mortgage for $300,000 at 5%. You’ve since paid down the mortgage to $250,000 and rates have fallen to 3%. Based on the interest rate differential, you’d owe the bank a total of 2% for each year remaining on the mortgage, for a total penalty of 4% of the amount owing. Thus, you’d be forced to come up with $10,000 before getting out of this mortgage!
That’s bad enough, but it gets even more complicated if banks play the posted rate game.
Most of Canada’s major banks have two mortgage rates. They have a posted 5-year rate and a discounted rate everyone pays. These days, a posted rate might be 4.59%, while the discounted rate is 3.29%.
You can probably see where this is going. When figuring out the interest rate differential, the lender will use the posted rate in order to maximize the difference in rates. Thus, a 1% difference in rates can become as high as a 2.5% difference, affecting a borrower’s penalty greatly.
There’s nothing a borrower can do to avoid prepayment penalties. But by discussing it with their broker before getting the mortgage, a borrower can choose a lender without posted rates, or one that allows more generous prepayment terms. They won’t avoid penalties completely, but they can take steps to minimize them.