Anyone who has considered breaking their mortgage early probably knows that there are penalties involved – steep ones.
With interest rates near historical lows, many people have either switched their mortgage or have looked into it.
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There are a couple ways to reduce the mortgage penalty that you pay out if you do make the switch.
Open vs. Closed Mortgages
A closed mortgage usually offers a lower rate, but also comes with restrictions on how much can be paid back each year (typically 20% maximum and mortgage payments can’t be increased by over 20%).
The interest rate is ‘locked in’ for a set time period (mortgage term). Closed mortgages are best for those who know they won’t pay the entire mortgage balance in full within the term.
An open mortgage usually has a higher rate but more flexibility because you can make extra payments (including paying off the mortgage early) without additional penalties. Open mortgages are best for those who plan on paying back their mortgage within the term.
Breaking a mortgage early usually involves a (sometimes hefty) penalty – the greater of three months interest or the interest rate differential (IRD).
Interest Rate Differential
The interest rate differential (IRD) is a number used to calculate your mortgage penalty if you decide to end it early. The calculation is fairly straight forward – banks compare your current rate and amount left on the term to a comparable rate and term currently being offered, then multiply the difference by the amount owing.
For example: you have a balance of $250,000 owing with 2 years and 6 months left (34 months) at 4.50%. The current 3 year rate offered by the bank is 2.5%. The interest rate differential penalty would be: $250,000 x (4.5% – 2.5%) x 2.5 years = $12,500.
Sounds simple, right? Not really – banks have added a twist that allows them to make the penalty even steeper.
How the System is Unfair
Banking regulations on mortgage penalties quietly changed in 1999 and gave banks more freedom in calculating the penalties. Since 2000, more banks have been using the interest rate differential formula because it is more lucrative.
The problem is that sometimes the bank adds an extra “factor” into the percent calculation to increase the penalty.
Since there are no regulations stating exactly how the formula is calculated, they can essentially use any rate they want to come up with the amount of the penalty.
They can also add any “factor” that they wish. Then they will then turn around and lend that money out again, further increasing their profits.
Which Penalty Do I Have?
The easiest way to see what penalty you have is to look at the mortgage documents, it should be clearly stated what the penalty is and how it is calculated. If not – contact your lender directly as they are obligated to explain the terms to you.
Click here to enter your information and calculate your penalty.
How Can I Reduce my Penalty?
If you already have a mortgage and are looking at breaking it, the only thing you can control is the amount you currently owe.
Most mortgages allow you to pay back a maximum of 20% of the balance owing per year as a lump sum. The key is how this is worded in the mortgage – if it is calendar year, you could pay back 20% in December and then another 20% in January.
Within two months, you could reduce your balance owing by 40% (assuming you have the cash available) and reduce your penalty substantially. Using the example above, 2 payments of 20% would have reduced the penalty by $5,000.
Then you need to make sure the bank calculates the penalty after the prepayments have been made – not before.
Another method is to play hardball with your bank.
They can’t change a written contract (your mortgage) but they can offer you a lower rate on your next one.
Conclusion: The point of breaking your mortgage is to save on interest – you may have to pay a penalty but you can save big if your lender knows you are willing to leave for a lower rate elsewhere. Do your shopping beforehand, know your numbers and explain to your lender you aren’t happy about the penalty and are prepared to go elsewhere.
Has anyone broken their mortgage and paid a large penalty?