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November 24, 2010If you originally secured a mortgage by going to your favourite Big Five bank for advice, then chances are very good that you signed up for a standard five-year fixed-rate mortgage (after all, it’s the banker’s favourite). Like most Canadians, when you signed your mortgage commitment you probably didn’t realize that you were also agreeing to pay a potentially huge penalty if you ever needed to break your contract early, and that’s because, at best, the customary wording is vague. Even experienced mortgage planners can only guess at what a borrower’s fixed-rate mortgage penalty will be, and like a moving target, the quoted amount often varies widely da
y-to-day and week-to-week. This is patently unfair to customers and (gulp!) more regulation is needed. In his March, 2010 federal budget, Jim Flaherty, Canada’s Minster of Finance, promised to standardize mortgage penalties in Canada, and today’s post will explain why this issue requires his urgent attention.
To be clear, I am not against charging a penalty to mortgagors who break their contract early. After all, if lenders don’t charge a penalty for early payouts, they still have to recover the extra costs and lost profitability somehow, and the only alternative is to raise interest rates for all borrowers (even those who stay until the end of their term). So it’s not the principle I object to, it’s the practice. Lenders use generic language to describe how prepayment penalties are calculated, and consequently, fixed-rate borrowers have no idea what their penalty will be until they call for a quote. The imprecise wording also gives lenders too much leeway, and since the method of calculation is not specifically disclosed when commitments are signed, borrowers have no way of comparing penalty policies between lenders. That’s a shame, because the difference in approaches used can easily translate into many thousands of dollars saved or lost.
To illustrate, let’s look at some examples in detail:
If you have a variable-rate mortgage, or if you have a fixed-rate mortgage that is five years or more into a term of greater than five years, then your penalty is limited to three-months interest.
Assume that you have a $300,000 mortgage balance and a variable rate of 2.5%. Your penalty is calculated by taking $300,000 and multiplying it by 0.625% (which is 3 months interest at 2.5%/yr). This works out to $1,875. Easy, and best of all, standard, since lenders all charge the same penalties for these types of mortgages.
The disparities appear with fixed-rate mortgages, which account for about two-thirds of Canada’s outstanding residential mortgage loans. For starters, a standard fixed-rate prepayment penalty clause looks something like this:
Your mortgage may be prepaid in full upon payment of a penalty that will be calculated as the greater of three-months interest or interest rate differential (IRD).
When current rates are lower than the rates offered at the time you started your mortgage, IRD is always the larger number, so in practice, lenders have been using IRD for the past several years. In theory, IRD is calculated by taking the remaining time on your mortgage and multiplying it by the difference between your contract rate and the rate the lender would charge if they re-lent the money to a new customer for the time remaining on your mortgage (this is called the “replacement rate”). Here is an example of how that would look:
Assume a $300,000 mortgage with an interest rate of 5% that has two years remaining, and assume that today’s two-year rate is 2.5% (the replacement rate). We take the mortgage balance ($300,000), multiplied by the time remaining (24 months, which we divide by 12 to annualize), multiplied by the difference in the rates (5% minus 2.5%). Here it is in short form: $300,000 x (24/12) x (.05 – .025) = $15,000.
Ouch. Well, that’s the price you pay for breaking your fixed-rate contract (by the way, a good mortgage planner knows a few tricks for lowering this number – and no, you don’t have to do anything illegal). You might think a penalty of that size is bad enough, but that’s actually the most borrower friendly way to assess IRD. Some lenders, chief among them the Big Five banks, won’t use your actual interest rate when ca
lculating your penalty. Instead, they use the posted rate that applied at the time you funded your mortgage (ah…so that’s what posted rates are for!) If we recalculate the penalty above using a posted rate of 6.5% (because posted rates are almost always at least 1.5% higher than discounted rates), that $15,000 penalty increases to $24,000. Worse still, some banks actually increase the penalty further by applying the original discount they gave you on their posted rate to their replacement rate, which means that instead of comparing 5% to 2.5%, they are comparing 6.5% to 1% to calculate your penalty. This increases your bill to a whopping $33,000, but the good news is that the bank may slightly discount this charge if you sign up with them for a new mortgage that starts the process all over again!
Let’s circle back to that innocuous penalty clause (in italics above). Does it seem fair that the same wording allows lenders a discretionary variance of $18,000 on a mortgage of $300,000 that has only two years left? Should it be legal/ethical/fair for a bank to charge such an exorbitant penalty with no transparency upfront? As a borrower, if Lender A was going to charge you a $15,000 penalty to break your mortgage and Lender B was going to charge $33,000 for the same option at the same point in time, wouldn’t you want to know that when deciding which lender to use?
I never imagined that I would be championing a cause for increased government regulation, but here I am. To be clear, I’m not asking the government to decide whether lenders can charge a penalty, or to decide how much is warranted in different circumstances. All we n
eed is proper disclosure so that customers know what they are agreeing to. I am confident that the market will take care of the rest. How about just a simple table that shows the cost of breaking your mortgage at the end of each year of your term, using today’s interest rates as a benchmark with the calculations shown in simple math, as in the examples above? Isn’t that all it would take?
Over to you, Jim.
16 Comments
great post Dave…there should be transparency through the whole process.
This IRD is brutal! I went to my bank (TD)in September to get a quote for breaking my 5 year mortgage after a year and 1/2 and was quoted a penalty of $3300. Fair enough as I was fully aware of a penalty that was apparently supposed to be around 3 months interest. After putting my place on the market I double checked with the bank in November and the penalty was now $11,000!!!??? I was never told that the penalty could fluctuate (especially this much in les than 2 months)and I went to 2 different brokers at TD and neither of them could even explain how these numbers are justified or even work. I am just shocked and appalled at the lack of full exposure on behalf of TD and even their ignorance on their own policies. This type of penalty does need to be standardized because it makes it nearly impossible to set a selling price if the penalty can vary so much.
RBC did the same but offered a 1.78 discount at time of selling me the mortgage from an inflated 5 year posted rate on their website. I thought ‘okay’ since the rate matched competitors 5 years rates in the marketplace at that time. In the 2nd and 3rd year of my term I ask about penalty to break and move into a new mortgage. Penalty $18,000! Why. …………..They took this artificial discount they gave me and applied it to their IRD calculation!!!!!!. Bait and Switch….discount because we want your business in the beginning. Oh that discount sir…you need to give that back to us. Sales practices are borderline criminal. When I complained away up to their CEO my answer back from the legal representative did not address the question on ethics, disclosure at time of sale and shady sales practices their branch people are followling. Reminds me of the Ally Bank Commercial put instead they take take away your truck (discount) and punch you in the face financially when you want to move. 10% prepayment. Largest bank is the worst. Stay the hell away from the major banks I will never touch RBC or give them a dime of profit ever again
Having same issue with credit union – even though I’m offering to re-up for another 5 years. Very little being discounted.
Has this been tested in court (small claims perhaps)? I find it hard to believe that these practices are legal.
I’m no lawyer Mike but I think if it’s disclosed in the contract you originally signed then its enforceable. That’s why it’s so important to read the fine print!
I was quoted a $12000 penalty from scotia bank… sold my house two months later and the rate ballooned to $16500. I was told that the policies had changed recently.
Shouldn’t the penalty go lower overtime?
Hi Manny,
A fixed-rate mortgage penalty is a function of both the time remaining on your mortgage and changes in interest rates. In your case, rates must have fallen between the time you were quoted the first penalty of $12,000 and the second penalty of $16,500.
In future, if you secure a mortgage through a non Big-Five lender your penalty will typically be much, much smaller (under almost any realistic scenario).
Best,
Dave
Where is the government on this, we were told 22,000. How is this allowed, it’s like forcing someone to do business with criminals. Have the banks not taken enough….the government needs to step in. We should be complaining to our mlas and they should be checking into how something like this is allowed.
I agree Cindy. The Big Five make about one third of their total mortgage profits from these outrageous penalties so this is big business for them. The government has talked about forcing more fair disclosure but most of that push came from Jim Flaherty and since he died it seems that all of that momentum has been lost.
TD penalized 1600.00 for breaking 2 and half months breaking the contract,
and no way ready to negotiable or absorb
have too many Policies in place !!!
not going back to TD !
I am having the same issue with Scotiabank. I am selling my house but will stay as a tenant. This is to allow me to retire in 2016. The buyer is willing to continue with Scotiabank and they would not be loosing any money. They refused my request and the buyer’s request because they know all my debt with them will be paid off with the sale of my house. I am a single parent and will loose $10K of profit because of this IRD. This is so unfair.
I am very sorry to hear that Godard.
Dave
Thank you so much for the information. It seems like we Canadians can’t do much if we decide to go for the Big Five. In your comment section, we already see people complaining TD, Scotiabank and RBC. I don’t have much faith for my current mortgage with BMO.
However, is there any update on this issue? I am not not sure when your wrote this since there is date indicated that on this page.
Hi Brandon,
Since I wrote this post in 2010 there has been some improvement in the way the Big Five discloses their penalties, but no change in the penalties themselves.
Best regards,
Dave
I chose a big 5 because I was sold on better client service, bricks and mortar and a probable better experience. Well after learning how much I have to pay to break the mortgage, the amount of time I remain on hold when I call in and the fact that I can’t remember the last time I went into a branch, I’ll never use a Big 5 again for anything mortgage related unless their rates are DRASTICALLY different than other lenders which I think is unlikely.
Hi Oscar,
There are plenty non Big-Six bank options available and, very often, at better rates.
It certainly pays to shop around.
Best,
Dave