The needs of a individual that is not in a relationship, are different than those of a couple, and different than those of a small family. Life can happen pretty quickly, and there may be some changes that need to happen to your living situation. Suddenly the single individual finds a partner and the home he purchased initially is starting to be on the smaller side. Maybe the small family have better employment opportunity elsewhere, and now feel the need to move.
The now couple start thinking of a family, but they still have 2 years left on their mortgage. That home cannot handle a 3rd family member. The now growing family needs to buy a bigger home. The small family now needs to move to stay close to work. However, neither of the two situations have factored in the interest rate differential.
The Interest Rate Differential (IRD) is what Chartered Banks, Monoline Lenders, and Credit Unions use to calculate your penalty for fixed rate mortgages. Different lenders calculate this very differently, and it takes an expert to ask the right questions. The IRD that most monoline lenders use is generally calculated by taking the difference of your interest rate minus the interest rate closest to the term that is left owing on your mortgage, multiplying it by the balance, and multiplying that by the term thats left on your mortgage over 12 months.
|Posted Rate - Actual Rate| * Balance * (months left of mortgage/12) = IRD
The IRD that a Chartered Bank often uses is much more costly. The wording used to justify the IRD is very poor but states that they also factor in the discount that you receive from their 5 year fixed rate. See the example taken from one of the Bank’s document on “Understanding the mortgage prepayment charge” from their website.
Current Rate - |Posted Rate closest to your remaining term - Rate Discount| * Balance * (months left of mortgage/12) = IRD
“interest for the remainder of the term on the amount prepaid, calculated using the “interest rate differential” (IRD). The IRD is the difference between the interest rate and our posted rate on the prepayment date for a mortgage with a term similar to the time remaining in the term and having the same prepayment options. If, when you obtained the mortgage, you received a reduced rate that is below our posted rate, we will deduct the amount of this rate reduction from the posted rate before calculating the difference between the interest rates. It is important to note that because the IRD calculation is the difference between your existing mortgage rate and today’s rate, if today’s rate changes, your IRD will also change. In addition, the IRD may change if payments are not made. “1
Let’s put this into perspective with real numbers and a real situation. So to breakdown the scenario, it looks like so:
Mortgage Balance: $200,000
Your Contract Rate: 2.89%
Term left on your mortgage: 27 months
Current 2 Year Rate: 3.49%
Original 5 year Discount Received: 2%
Monoline IRD
|2.89% - 3.49%| * $200,000 * (27/12) = $2,700
Chartered Bank (Discounted Rate Penalty)
2.89% - |3.49% - 2%| * $200,000 * (27/12) = $6,300
As we can see, that the example used above results in quite costly penalties — But what if you had a Variable Rate Mortgage (or Adjustable Rate Mortgage)? For the Variable Rate, the penalty is only 3 months of interest.
Interest Rate * Balance * (3/12) = IRD
Let’s calculate the penalty by using the same information as above and that your rate is the exact same.
Variable Penalty
2.89% * $200,000 * 3/12 = $1,445
When buying a home, everyone’s first choice is to get the best 5 year fixed rate. While for some, this may be a good option, for others not so much. When the homebuyer is thinking from A to B, the experts are thinking A to Z; I’m thinking long term. I want you to be asking as many questions as you can think of regardless of how irrelevant you may think it is. This could be the difference of saving you thousands of dollars. Give me a call today to go over your mortgage options.
1= Royal Bank of Canada, Understanding the mortgage
prepayment charge. Retrieved July 31st, 2018, from http://www.rbcroyalbank.com/mortgages/pdf/MortgagePrePaymemt_E.pdf