How to reduce mortgage penalties

Backing out of a mortgage early? Here’s how to limit fees.

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A rise in interest rates appears imminent, so folks with big mortgages might want to lock in the current low rates now! But for some, that means getting out of an existing mortgage early. Trying to discharge your mortgage early comes with a cost. After all, banks are in the business of making money, right? The sad truth is banks can be very greedy when it comes to calculating the interest penalty on a mortgage you’re trying to renew early.

Once upon a time, the standard in the industry was to charge a three-month interest penalty for early discharges. CMHC paved the road for that because they had it written into their policy. But when they removed it back in 1999, they’ve created a feeding frenzy among banks who now want to charge what’s called the Interest Rate Differential: a calculation they can do any way they want because there’s no uniform system among lenders or regulation by the Bank Act.

The idea behind the IRD is to compensate the lender for any loss due to a mortgage being paid out early and then the funds being lent again at a lower rate.

Common practice has banks comparing your interest rate to their current interest rate for the term closest to the amount of time left on your mortgage. So if you had two years and four months left on your mortgage, the bank should be using their three-year rate. But they don’t always do that. Sometimes they use a lower rate they’re offering for the calculation.

Since there’s no rule about which rate to use, they can use any rate they want. With a 2% different between one- and five-year rates, that’s a lot of wiggle room. On a $450,000 mortgage, that 2% would cost you $9,000 in penalty interest.

There is something you can do however. You know that annual prepayment you’re allowed to make on your mortgage? It’s usually between 10% and 20% of your initial mortgage amount. Make sure that your bank has applied that prepayment before they calculate the IRD. While this should be standard practice, banks only do it if you make ‘em!

You could also make it clear to your lender that if they make it painful to renew with them, you’re happy to go shopping to find a new lender for your mortgage. Make sure you’re ready to do some work; don’t just make the threat.

The government knows that banks are making record profits on the backs of average Canadians by playing the renewal penalty game. In fact, they promised three years ago to make the calculation consistent. But promises are easy to make, not so easy to keep, so nothing has changed. You’re going to have to advocate for yourself if you don’t want to be taken to the cleaners.

5 comments on “How to reduce mortgage penalties

  1. So if you had two years and four months left on your mortgage, the bank should be using their three-year rate. But they don’t always do that. Sometimes they use a lower rate they’re offering for the calculation.- In this case bank will be using 2 years rate..however the if the remaining term is 2 years and 7 months then the bank will use 3 years rate ..please provide right information to the public…

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  2. An option that should have been mentioned is 'blend and extend'. Yes, the rate is averaged between your current rate and the posted rate, but there are no fees. I recently did this and am 1.5% lower, in a 5 year term, kept the now vanished amortization, and paid no fees.

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  3. Do you mind if I quote a few of your posts as long as I provide credit and sources back to your website? My website is in the very same area of interest as yours and my visitors would genuinely benefit from some of the information you present here. Please let me know if this alright with you. Thank you!

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    • Hi, you are free to paraphrase what you see on MoneySense.ca with links back to MoneySense.ca but you cannot reproduce the work as-is. Thanks for reading!

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      • We recently renewed our mortgage because the interest rate was 2.99% just slightly lower than our current rate of 3.99%. Our mortgage was due for renewal in November 2015 but we renewed April 2014. We got charged a fee of $1255 which was taken out of our account on May 1st. It was all explained to us that it was the right choice to make as there is not certainty about where the rates will be next year but I still feel like we were “taken” to have to pay that fee. Our mortgage was about $55,000. The only thing that gives me peace with it is that it’s fixed so we are safe for 5 years and should have it paid by then with the 10 /10 option that the bank offers.

        Reply

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