There is nothing new about mortgage penalties; however, the size of penalties these days is catching many people off guard, especially in the Vancouver real estate market where housing prices (and their mortgages) are higher than the rest of the country so these penalties are even more amplified.
A mortgage penalty is triggered when a borrower ends the mortgage contract before the end of its term, which is typically 1 to 5 years in Canada. For example, when a property is sold, any mortgage on it will automatically be terminated on the closing date of the sales transaction.
Why do penalties seem higher these days?
The reason that penalties seem higher these days is not due to changes in mortgage contracts but rather due to the fact that we’ve recently gone through a period of low and declining interest rates.
Mortgage contracts typically state that the penalty will be either:
- three months’ interest or
- the interest rate differential, whichever is higher.
In times of relatively flat or climbing rates, the penalty will usually be the first of these two options: three months interest. But during times of falling interest rates, it’s more likely that the interest differential clause will being triggered.
The interest differential calculation includes, generally speaking, all of the interest you would have paid for the balance of the term minus all the interest the bank can get by re-loaning that money to somebody else at today’s rates. The tricky part is how financial institutions actually calculate the differential. In the fine print of the mortgage contract, it mentions an interest rate “discount”, which was the difference between the rate posted on their website at the time you took out the mortgage and the rate actually extended to you for the mortgage. When this little discount is factored in, it could make your penalty huge. For example, a 2% discount on today’s 3% mortgage rates represents a much larger proportion than a 2% discount on the 5% mortgage rates that were posted 2-5 years ago.
How are “interest differential” penalties calculated?
Here is a typical differential penalty calculation:
A = Annual mortgage interest rate stated in contract
B = Current interest rate posted on their website for a closed mortgage closest to the remaining time left on mortgage
C = Discount stated on mortgage contract
D = Number of months left on the mortgage
E = Total principle remaining on mortgage
Penalty = A – (B – C) x D/12 x E
For example, if you have a mortgage with remaining balance of $300,000, remaining term of 33 months, contract rate of 3.5%, discount of 2%, and the bank’s website says 3 year closed mortgages are currently going for 3.39%, then the calculation would be:
Penalty = 3.5% – (3.39% – 2%) x 33/12 x $300,000 = $17,407.50.
Seriously, the penalty is over $17,000 for a $300,000 mortgage!
How can I minimize or eliminate this penalty?
Start by asking your financial institution to help you come up with a strategy to minimize your mortgage penalty. Keep in mind that banks are not really your friends, rather they are here to make money off you so you need to be firm with them. Here are some sample strategies that we’ve seen used with success.
- Ask your bank for a discount on the penalty. Most banks will give you up to 20% discount upon request. In special cases, if you escalate the issue to the bank manager then you might even get an additional discount.
- Make one or two lump sum pre-payments on your mortgage before the closing date. Most mortgage contracts say you can make one lump sum payment each year so, depending on your anniversary date, you might actually have time to squeeze in two payments to reduce the amount of remaining principle before the closing date and therefore reduce the penalty.
- Port the remaining mortgage to a new property. Most financial institutions will refund your entire penalty if you port the mortgage to another real estate investment within 120 days. Keep in mind that most of the terms must stay the same (except you usually have a choice to keep the amortization period the same or have it extended).
- Port the remaining mortgage to an existing property which already has a mortgage but has enough equity to carry another mortgage. Keep in mind that you will now have newly freed-up funds from the ported mortgage to spend on something else so, if possible, make a lump sum payment on the existing mortgage and pay off any other debt that you may have. Extend the amortization periods for both the existing and ported mortgage to keep the overall payments down to a comfortable level close to what you had previously. In other words, use the ported mortgage to simply refinance existing debt. This scenario will reduce your penalty altogether, but only works if your existing property has sufficient equity to carry two mortgages.
Our Vancouver-based real estate team has many years of experience with property transactions so we’ve seen, and experienced, almost every scenario that you can imagine. We can also refer you to our network of financial specialists who know how to maneuver through these mortgage penalty mine fields and will help you strategize to achieve your goals.
YourHomeTeam works with home sellers and buyers all over the west side and east from Point Grey, Kitsilano, Kerrisdale , and False Creek to Main, Fraser, and the East Village, and every place in between.
*Written by Annette Saliken, YourHomeTeam realtor with Sutton Westcoast Realty ~ Sept 2015