Chad Moore Calgary Mortgage Broker

When paying out a Mortgage, the lender will charge the greater of a three month interest penalty OR a interest rate differential penalty (IRD). This post is to explain IRD penalties.

Interest Rate Differential (IRD) Mortgage Penalties Explained:

1. Why charge a penalty at all?
2. What penalty formula is applied?
3. Different IRD penalty formulas explained.

Why Charge A Mortgage Penalty At All?

Let’s remember, a Mortgage is a contract. Corporations have planned to earn the revenue from the interest paid on your Mortgage to make a profit. When breaking the contract, the lender (investors) lose out on the money they planned on earning, so they penalize the client.

For example, the Mortgage lender lent me money (Mortgage) and planned on a certain amount of profit/revenue from me as a client. If I break my Mortgage 3 years into my 5 year term, the lender essentially needs to re-lend the money I pay back for 2 years to make up my original 5 year commitment. There is a cost to the lender for this: administrative processing, reinvestment of the money, any lost revenue due to changes in the market. These changes in the market is where things can become expensive (interesting?) …

What Penalty Formula Is Applied?

For a fixed rate Mortgage, the lender will charge the greater of a three month interest penalty OR a interest rate differential penalty (IRD).

For a variable rate Mortgage, the penalty formula will only ever be a three month interest penalty.

The formula for a three month interest penalty is this:

[(Mortgage amount * interest rate (as a decimal)) * 0.25].

Now with numbers: [($250,000 *0.0289) * 0.25] = $1,806.25

The formula for a interest rate differential penalty is this: a mess!

IRD penalty formulas are not regulated by any level of government or regulatory body. It’s the wild west out here.

Applying the same philosophy of Mortgage lenders taking money back that was on the books to earn profit/revenue and now losing out on that …they charge a penalty.

For example, I plan to pay back my Mortgage 3 years into my 5 year term. To fulfill my original 5 year commitment, the Mortgage lender will need to re-lend that money for 2 years.

The lender calculates the difference between my 5 year Mortgage rate and the 2 year term Mortgage rate which creates a interest differential. The difference between these two rates is applied to my outstanding Mortgage balance.

In general, that is the IRD penalty formula. I called this “a mess”, so here’s where things get messy!

Different IRD penalty formulas explained.

Some lenders (big banks) will create a artificially high interest differential so the payout penalty is even more expensive.

Keeping with the same example of paying out my Mortgage 3 years into my 5 year term …some Mortgage lenders will use the 5 year posted interest rate, at the time I took out my Mortgage, and compare that with the 2 year term Mortgage. Posted interest rates are much higher than actual market interest rates so the interest differential is greater, making the Mortgage penalty greater. Do you see how that’s a little sneaky?

I’m seeing IRD penalties come in relativley high these days. Due to artificially suppressed bond yield curves, Mortgage rates have tanked. We know this. Shorter term rates have also steeply dropped which is creating larger interest rate differentials (for even great interest rates from 18 months ago).

And Here’s The Kicker …

Mortgage interest rate is a part of the Mortgage puzzle. I don’t think it’s the entire puzzle, so let’s agree interest rate is a big piece of the puzzle. Fair?

Well, there are some Mortgage products in the market that frame Mortgage interest rate as the entire puzzle. And lot’s of people make that choice.

You know this, life is about trade offs. When choosing a Mortgage based on interest rate, Mortgage lenders strip away features and benefits that might come in handy in the future.

For example, some Mortgage products require the owner to sell the home to break the Mortgage. They may have gotten a good rate 24 months ago? But that rate would be offensive to quote in the market today. They can’t make a change.

Another example are Mortgage with known high penalty formulas. These restricted Mortgages have penalty formulas of 2.5% or 3% penalty formulas. Again, the penalty is so high, accessing low rates today does not net any savings for the clients. Good rate at the time. Not much for options and flexibility in the future. And here we are, in the future.

Get it? Rate is one thing. And I acknowledge a big thing in a Mortgage. But not SO big that I become blinded by it.

Sorry Not Sorry, Call To Action:

Let’s get together and chat about your Mortgage and how you can make a change in today’s lending environment.

Talk soon,
Chad Moore

403-809-5447
Chad@canadamortgagedirect.com

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