Standardizing Mortgage Penalty Calculations

Rob McLister, CMT
Two years ago, the government pledged to “standardize the calculation and disclosure of mortgage prepayment penalties.”
It addressed the disclosure problem last week (see:New Mortgage Penalty Disclosure), but it has done nothing to standardize the actual calculation itself.
This lack of action irritates some consumer advocates. They feel that lenders’ convoluted and algebraic penalty formulas allow them to overcharge people. (How to define “overcharge” is another question.)
As to why the government chose not to standardize penalty calculations, a Department of Finance (DOF) official told us:
“Mortgages can have a variety of mortgage prepayment calculations. Standardizing the calculation of the mortgage charges could have resulted in changes to lenders’ product offerings and created a disincentive for some lenders to offer discounted rates to the most creditworthy borrowers.”
The DOF concluded that, “This would not have been in consumers’ best interests.”
Instead, the DOF says “The Mortgage Prepayment InformationCode of Conduct focuses on disclosing key mortgage prepayment information that equips consumers to understand and benefit from a choice in mortgages.”
Unsurprisingly, that leaves two camps in the penalty standardization debate: Those for it and those against it.
Pro-Standardization
Some people are outraged at the thought of banks profiting from mortgage penalties. We’ve all heard stories of eye-popping prepayment charges in the tens of thousands of dollars.
There are many people who would therefore like to cap mortgage prepayment fees.
Others would prefer to see a standard penalty formula that is applied consistently regardless of the lender. In this case, breaking a mortgage with a given mortgage amount and interest rate would trigger the same penalty regardless of the lender.
Another idea is to allow lenders flexibility in how much they charge, but to legislate the penalty range and calculation method. In that case, all lenders would calculate the base penalty the same way. They could then charge a simple multiple (e.g., 1X, 2X, etc.) of that penalty at their discretion, subject to:
The base penalty formula being straightforward
The multiple being disclosed up front
The total penalty not exceeding the maximum allowed by law.
The Case Against Standardization
The original intention of mortgage penalties (more accurately called “interest compensation charges”) was to make a lender whole if the borrower backed out of a mortgage contract that he/she voluntarily agreed to.
Without such compensation, the lender would have less ability to cover costs and repay depositors and/or investors who provided the money to lend to the borrower.
Put another way, a mortgage penalty is similar to the compensation we might expect if we bought a 5% GIC and the bank cancelled it when rates dropped to 2%. We’d demand the rate we had been promised, especially if there was no place left to invest at a similar yield.
Most of the time, mortgage compensation charges are not the cash cow people think they are. (There are exceptions of course.) Last quarter, for example, CIBC reported that its prepayment fees collected from customers were actually lower than the true breakage costs to the bank. That appeared to be an industry-wide trend, according to CIBC's earnings release.
In many cases, when a customer breaks his/her contract, penalties only cover the interest a lender loses; lenders incur many more expenses when a mortgage is broken. Lost interest is just one.
Further, many would argue that standardized penalties are self-defeating. Forcing lenders to apply a single penalty formula for early termination would restrict lenders from charging what they deem necessary to become whole.
That one-size-fits-all penalty would likely drive lenders to add a rate premium to every single mortgage to compensate for the lost interest revenue. No one would be further ahead, monetarily anyways.
In a free market where mortgage lenders can generally choose what interest rate and fees to charge, it's difficult to justify legislating a specific calculation method for interest compensation. Lenders have different costs, different mortgage features, different mortgage flexibility, and different profit margins. Being forced to levy the same penalty for a given rate and loan amount makes little business sense.
Mind you, some lenders might be able to tolerate a compromise in which a set method is legislated for calculating a range of penalties. In that case, all lenders would determine the "base penalty" the same way, based on the borrower's contract rate, term remaining and standardcomparison rates. A lender could then charge some multiple of that base penalty, up to a regulated maximum. This system would help borrowers compare lenders’ penalties more easily, while still providing flexibility for lenders to recoup costs as needed.