Mortgage Penalties

Or ... How much will I really save? Like, really? 

It's been a crazy millennium so far for mortgages. Long gone are the olden days of what at the time seemed reasonable 6-10% interest rates pre Y2K (remember that fun?). Instead we have had a steady mantra of 'rates won't go lower' and yet they continue to do so - just months ago the industry-shocking rate of below 3% was announced and experts were all like 'WTF!!! That's insane.'

Then this monthin Canada, another mortgage lender announced a 1.99% interest rate and industry experts heads exploded.

DO NOT PRESS PLAY IF YOU DO NOT WANT TO WATCH SOMEONE'S HEAD EXPLODE:

ah...science.

Moving on...now keep in mind that the interest rate in it's essence is the amount that a lender charges you for lending you money. If I lend you $100 and then get you to fill out a bunch of forms that legally say you will be paying me back $110 in six months then I am charging you a flat 10% interest fee.

Pretty simple at it's core. But nothing is simple in banking finances. There are a lot of little tricks to hide that true number, as consumers all love a deal. You got a weed whacker for $129 at Canadian Tire? I bought one at Sears for only $125! Sucker! Banks charge you a semi-annual interest rate, meaning that 10% isn't actually 10% but rather 5% charged to your amount owing 2x a year. And that's just the tip of the iceberg and also maybe for another column.

When is it worth breaking your mortgage?

What with the continual downward trend of interest rates dropping perhaps you are thinking it wouldn't hurt to buy in now. But most mortgages are already pretty low as one of the 'tricks' to get you in the door in recent years was the 'if you qualify for a 5% loan, we will give you a 4% loan' type offer. Make sure you know exactly how much interest you are paying and what the bank's posted rate is (this will come up later).

To answer the question and to keep things simple while using as little math as possible, if you see a rate that is 30 basis points below your current rate, it's worth the time to just run the numbers. For example, take your current interest rate and minus it by .30. Is there a rate out there equivalent or lower than that? You could be spending money you don't need to. If you are paying 3.75% - .30 then a 3.35% rate means you may stand to investigate switching for as of May 2014, rates in Canada dipped below 3%. Depending on the penalty for breaking your existing mortgage, you could see big savings over the long term.

That said; Yes, it could be too good to be true. The biggest factor in switching mortgages is the Penalty clause that most lenders/big banks have inserted in their mortgage contracts. 

Are you allowed to break your mortgage?

In most cases the answer is yes. As Big Bank brand loyalty continues to wane their customers are turning to alternative smaller lenders as a viable option in pursuing mortgage purchases or renewals. Nearly 30% of people purchasing mortgages (which is all it is - people buying money) have decided to sign with non-big bank lenders in the last decade. It's a trend that shows no sign of decreasing. 

That said, the way that most lenders keep your business is the Penalty clause, usually something called the Interest Rate Differential (or IRD) or three months interest payments, whichever is larger. 

The IRD penalty is basically your lender saying 'hey you promised to pay X amount of interest at 3.49% for the next three years still. Now someone is offering you a 3.09% interest rate if you switch? What about our promise? Where's your loyalty to our continuing service charges, our record profits and continuing lack of human interaction until it's time for you to give us more money? Therefore we demand that you pay us the money we thought we were going to be getting from you over the next four years so we still make a huge profit."

i also offer free hugs...

Sometimes, the IRD also won't be the interest rate you are paying but the posted interest rate of that day or in some cases what you 'qualified for'. So, you borrowed $1000 at 4% ($40) but the posted rate is 5% ($50) then you will be paying that larger number instead because that is just what banks can do.

In other words, the question you should ask yourself isn't “Am I allowed to break my mortgage?” it’s more like: “How much is breaking the mortgage going to cost me?”

Which leads to....

What will breaking my mortgage cost me? 

If you have a variable rate mortgage, the penalty as mandated by the Canadian National Housing Act is always equivalent to three month's interest. So if you are paying $1000 a month and the interest rate portion of that is $400 then you multiply that by three and you get your penalty - in this case $1200.

The next step is finding out if refinancing into a lower variable rate mortgage will save you more than $1200.

What about my Fixed Rate Mortgage?

When rates started this decline back in the early years of Y2K, bank experts continually stressed that these rates won't go any lower and you should lock in as soon as possible to avoid the inevitable rate hikes. That's what I was told. And you know what? That hike never happened and it's ten years later. That said, a lot of people still prefer the security of a fixed-rate mortgage although it comes with a much higher penalty and is a bit more difficult to calculate.

Fortunately, most banks have an online mortgage pre-payment calculator option on their websites so they don't have to personally tell you how much of a penalty you would be paying. More often than not, someone with a fixed rate mortgage will be paying the IRD - and it will be in the thousands of dollars to break. It gives you a glimpse of just how much money you pay to the bank in interest alone over the course of your term and can be quite disheartening. A mortgage broker can help you find out your penalty but remember - don't kill the messenger!

Are there any other costs? 

Most likely. Refinancing or breaking your mortgage to switch to a new one, isn't much different than applying for your first mortgage. You will have to go through the process again; filling in an application, doing a credit check, verifying income over the last two years. Remember, you are most likely going to be switching to a new lender who knows nothing about you. Banks cannot just 'exchange' your information. Your new lender may also request to have a title search done (to make sure there are no legal claims against the current mortgage), and there may be appraisal and inspection fees. A broker can help you determine how much extra costs may be involved but a fair estimate is around $1,000.

If you are planning on selling your house in a few years, it’s probably not worth it to refinnace as you may may barely break even. There is a possibility you could even lose money due to the penalty and administrative costs. 

On the other hand, refinancing can save you a bundle depending on your current mortage contract.

In conclusion

How much you save will take some homework on you or your mortgage broker's part BUTTTTT... if you discover you will save a few thousand dollars in interest payments to get a new mortgage you will be glad you did it.

Sure, the industry experts keep talking about the eventual rise in interest rates but the truth is, unless there is a very, very large influx of capital into our economy that comes from somewhere other than the government (read taxpayers), interest rates won't be increasing any time soon. There is too much of a disparity between economic classes, too much individual debt to credit cards and student loans to allow for a large jump in interest rates. A 1% jump in interest? On a $2000 mortgage that an extra $2400 a year that most people may not be able to afford. What happens? People sell their homes, attempting to downsize. They either do or don't. Bankruptcies increase. Banks take possession of foreclosed homes - it's a repeat of the US housing crisis during the peak of the Bush years.  

No Canadian wants that. Especially not a Canadian government that is up for re-election next year. 

Nooo, the other re-election.