Beware of Mortgage Penalties

I originally posted a breakdown of how mortgage penalties are calculated by different lenders on January 4, 2011.

A recent article outlining how TD Bank charged a $30,000 mortgage penalty to a woman forced to sell her home due to the Covid-19 pandemic shows how this remains relevant today.

WE TOOK THE MYSTERY OUT OF HOW PENALTIES ARE CALCULATED

We decided this needed a more detailed explanation… but a strange thing happened when we started to answer these questions. We made a startling discovery. We caution you – the results could get your blood boiling if you’ve had to pay a penalty!

We found that the banks have shrunk or reduced the spreads between their Posted and Discounted rates on shorter-term mortgages over the past few years… and this has had a huge impact on Interest Rate Differential (IRD) penalty calculations.

QUICK FACTS:

• The most popular mortgage product is a 5-year fixed
• The most profitable is a 5-year fixed
• On average, a mortgage is refinanced or someone moves every 3 years
• Mortgage penalties affect more people than you think!

FIRST, YOU NEED TO UNDERSTAND THE HISTORY OF MORTGAGE PENALTIES

To better explain the above statements, I need to explain why mortgage penalties exist at all. To do this we need to go back in time… in the 1990s, mortgage penalties were capped at 3 months’ interest (for all CMHC insured mortgages). This was a policy that CMHC implemented. Most banks just used that same formula for non-CMHC insured mortgages. Some banks still had an IRD penalty clause in their standard charge terms, but the formula for calculating this was very different from today.

Back then, a few things were different… Discounted rates on 5-year terms were only 0.50% to 0.75% off Bank Posted rates. If you had 3 years remaining in your 5-year term, the banker went to the rate sheet, looked at their 3-year POSTED fixed rate and, if your rate was higher, then they calculated the IRD (usually, a nominal amount because the banker only had posted rates to compare with). If your rate was lower, then the banker could impose a 3-month interest penalty or NO PENALTY. That’s right, no penalty. It was up to the banker’s discretion.

But I’m getting ahead of myself. The reason or justification for having an IRD penalty in the first place is to compensate the bank for any loss that may be incurred when re-lending the funds.

HERE’S A DIRECT QUOTE FROM THE TD CANADA TRUST WEBSITE:

“The IRD amount is calculated on the amount being prepaid using an interest rate equal to the difference between your existing mortgage interest rate and the interest rate that we can now charge when re-lending the funds for the remaining term of the mortgage.”

Did anybody get that? The IRD penalty is there to compensate the bank for any loss due to a mortgage being paid out and then to have to lend funds out again for the remaining term at a rate that’s less than what they had in the contract. I don’t think anyone would have a problem with that. After all, it’s a business and they can’t be expected to take a loss.

But somewhere along the line, this reasoning got lost or forgotten. The current IRD penalty calculation is OVER-CHARGING borrowers. And the banks have shrunk their spread between posted and discounted rates on shorter-term mortgages, causing borrowers to pay record mortgage penalties in the $10k, $15k and $20k range and higher!

Let’s fastforward to the end of 1999. CMHC quietly removed the 3-month interest penalty cap from their policy… probably because of competition from Genworth Financial Canada (formerly GE Mortgage Insurance and a competitor to CMHC). Banks slowly changed their own policies to allow for IRD to be charged… and today we have banks using an unfair penalty calculation that does more than cover any potential loss… it makes the borrower pay an unfair amount!

MORTGAGE PENALTY CALCULATIONS

Let’s look at the numbers. Let’s use a $200,000 mortgage that was taken out in December 2008 at 5.54% for a 5-year fixed term. The Posted rate was 6.95%, giving us a discount of 1.41% off the 5-year fixed rate. In January 2011, the 3-year posted rate was 4.15%. (We’re using TD Canada Trust in this example because they have a clear explanation and formula on prepayment penalties on their website… but this formula is similar to what the other Big Six banks are using.)

Using the IRD formula from their website, the penalty would be approximately $16,800. That’s equal to 18 months of interest!! Here’s what’s happening… The banks are using your original discount given at the time of the mortgage. They take that discount, in this case, 1.41%, and subtract that from their posted 3-year fixed rate (4.15% – 1.41% = 2.74%). The problem is that NONE of the Big Six Banks are advertising a 1.41% discount off their 3-year rate… The best advertised rate that we could find with TD Canada Trust is through their broker channel. That rate is 3.60%. So why are they using 2.74% to calculate your IRD penalty?

What’s even more disturbing is that this formula has gone unchecked by governments, regulators and watchdogs for almost a decade. Wait, it gets worse… we all know that mortgage rates have been at record lows for the past 18 months. This alone would cost borrowers even more to get out of their mortgage. The banks don’t seem content with that… They have shrunk their spread on shorter-term mortgages, making these penalties higher than ever.

In 2007, TD had a posted 3-year fixed rate of 7.35% and a discounted rate of 6.05%… that’s a 1.30% discount. But in January 2011, the posted 3-year rate was 4.15% and the discounted rate was 3.60%… a discount of just 0.55%.

That reduced posted rate is costing borrowers dearly. And, to put this in a better context, if the posted 3-year fixed rate was 1.30% higher than the discounted rate, then the penalty would be approximately $11,640 instead of $16,800. (As an aside, if this was 1998, your penalty would cost $8,340 because the bank only used the Posted rate when calculating the penalty.)

End result: HIGHER MORTGAGE PENALTIES for borrowers, MORE PROFIT FOR BANKS.

We need to get more attention on this subject. These penalties are unfair, unjust and the logic isn’t adding up to the original reason for having mortgage penalties to begin with.

Your best interest is my only interest. I reply to all questions and I welcome your comments. Like this article? Share with a friend.

Steve Garganis: 416-224-0114; steve@canadamortgagenews.ca