Posted by John Doe
If you are thinking of buying your first home then you are likely not thinking of mortgage penalties. Instead, you are probably more worried about paying the mortgage than any penalties that may result if you fail to pay it off. Evidently, paying close attention to your interest rates is very important, but the importance of mortgage penalties should also not be underestimated. Also, while most Canadians do not plan on ever breaking their mortgage it pays to plan ahead for the possibility, as mortgage penalties can end up costing you more than you expected.
Fact vs Fiction
For instance, some people believe that mortgage penalties in Canada are not a serious issue in terms of how lenders calculate fixed rate penalties because rates have hit record lows in Canada. However, in reality, nothing could be further from reality. In actuality, the cost of how penalties are tabulated is never more pronounced than when the rates rise over a prolonged period or remain flat.
Many believe that this is exactly what will happen in the not too distant future, so Canadians need to be careful when considering mortgage penalties. For instance, if you have a $250,000 mortgage and break it 2 years earlier than the term then you may have to pay up to $7,000 in mortgage penalty fees. As can be seen, mortgage penalties in Canada do matter, and we will further discuss why people break their mortgages, how mortgage penalties in Canada work, and how they are calculated in this article.
Why Would Someone Break Their Mortgage?
Most mortgages in Canada are for a five year period. As such, a mortgage is a long-term commitment, and life has a way of throwing curve balls to otherwise fiscally sound and prudent Canadians when they least expect it. For instance, you may suddenly be laid off due to downsizing or may be dealing with an unexpected divorce. A death in the family, an unexpected medical diagnosis, and several other unforeseen life events can hit a family from out of nowhere.
If you were to lose your job and find another job that pays significantly lower, then you may feel that you won’t be able to keep up with your current mortgage payments. As a result, you may choose to opt out of your agreement and decide to sell your home before your mortgage term is up.
Five Year Mortgages
As mentioned, the five-year mortgage term is very popular amongst Canadians who buy their first home. Many people are also willing to pay a premium so that they can have peace of mind that their rates won’t go up during the five year period. It should also be noted that while the five-year mortgage term is very popular, the average 5-year mortgage, in actuality, will only last three or four years in Canada: This is a serious problem, as many Canadians do not realize how costly mortgage penalties can be. Many people who break their mortgage term early will have to pay four or even five-digit penalties for breaking their mortgage terms prematurely.
How Do They Work?
Mortgage penalties in Canada are actually different depending on whether you opt for a fixed rate or variable mortgage. For instance, if you have a fixed rate mortgage then it will generally be the greater of 3 months interest and the interest rate differential (IRD). In some cases you may only have to pay three months worth of interest payments as your penalty, but, in most cases, you will have to pay significantly more because of the IRD.
What is IRD?
The IRD is essentially a formula that factors in the money that lenders potentially lose when you fail to keep your mortgage intact. The IRD will also take into account the interest rate that would apply if your lender were to lend you the money today. As for a variable rate mortgage, the amount you would have to pay for breaking your mortgage would just be 3 months worth of interest payments.
Fixed Rate IRD
In regards to the IRD and fixed-rate mortgages, some lenders will use the discount rate in order to determine the IRD. The discount rate refers to the lower rate that they offered you when you initially signed up with them. Other lenders may choose to use the posted rate instead; which is the mortgage rate that lenders actually promote to their borrowers.
When you are having your discussion with your lender please make sure that you ask them which rate they will use. For instance, if they choose to go with a posted rate, then it can cost you a large sum in the future. Some lenders will even go one step further and implement even harsher penalties for breaking a mortgage with them; such as 3% of principal or up to 6 months worth of interest payments instead of the usual 3 months.
Before you sign up for a mortgage you should check to see if it’s portable. By doing so, if you decide to move in the future then you will have the option to blend and extend it. That is, you can amalgamate your current mortgage rate with the mortgage rate that is currently available today for a new term, and without having to deal with the costly mortgage penalty.
If you would like to learn more about why mortgage penalties matter in Canada then please do not hesitate to contact us. We can be reached at 1-866-417-8805, or you can contact us here.