Why Does Higher Posted Rate and More Discount Trigger Higher Penalty?

Maurice Kwok, MBA CMA CGA

Mortgage and Real Estate Networking - Canada (LinkedIn)


To many homebuyers and real estate practitioners, how to calculate penalty, or called bonus interest, in breaking a fixed rate mortgage before maturity is a mystery. Believe it or not, many bank account managers don’t know the basis of penalty calculation. She will input your sale closing date in the system, print out an estimated penalty statement, but she will emphasize that it is “For Indication Only” and even highlight these 3 words with a yellow highlighter to protect herself/bank.

Penalty for variable rate closed term is easy: 3 months interest only. If you break a variable rate closed term of $500,000 and your net rate is 3%, then your penalty is about $500,000 x 3% x 3/12, approximately $3,750. But there is a subtle issue if you never exercise this year 10% or 15% or 20% bank's allowed maximum annual prepayment. Technically you can agrue that you pay the 10%/15%/20% one minute before you break the mortgage. Some banks automatically give it to you, some banks may not. But 10 out of 10 home sellers don't know the subtle situation.

Penalty for fixed rate closed term is complex: Greater of 3 months interest (per above) and IRD Interest Rate Differential. What is IRD?

e.g. If you purchased a house on 4/22/2011 for $685,000, and you locked a 5 year fixed rate when the posted rate was 5.49% and you received a discount of 1.79% from your bank, or contract rate of 3.70% for maturity on 4/21/2016. If you sell your house and close it on 3/22/2013 when the outstanding principal balance is $500,000, then the bank will use today’s 3-year posted rate minus the original discount you received, and compare the calculated net rate with your contract rate, and multiple it with the no. of months from now till maturity, and the outstanding principal.

Is it still too complicated?

A) 3 months interest = $500,000 x 3.70% x 3 / 12 = $4,625.
B) IRD
(1) use today’s 3-year posted rate 3.55% minus 1.79% the original discount you received on 4/22/2011 = 1.76% calculated net rate
(2) compare your contract rate with the calculated net rate. If the latter is greater than your contract rate, then there is no IRD. But in this case, 3.70% minus 1.76%, the IRD is 1.94%. Your bank suffers 1.94% for 37 months because of your early termination today.
(3) calculate IRD penalty: $500,000 x 1.94% x 37 months / 12 months = $29,908.
I did one refinance from another bank 3 years ago and the client was charged with $30,500 penalty, very similar scenario.

Hence, don't be happy if you get 2.89% today, because you have received a discount of 2.25%. If you sell your house 2 to 3 years later, you may port the outstanding mortgage to the new mortgage (if you buy again within a gap of 3 months, and if you are qualified again). But you should be prepared to pay a huge penalty. Of course if the rate rises by 2%, 3%, then there will be no IRD. But bear in mind the short term (1 to 3 years) posted rates are usually 1.50% to 2% lower than the 5-year rate. Check with your friends/clients, 1 out 3 or 4 clients who signed up a 5-year mortgage ends up paying penalty.

This accounts partially why Canadian banks do not want to lower the 5 year posted rate by 1% but offer you 2.25% discount. There are further implications, let's discuss tomorrow.