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How Are Mortgage Penalties Calculated?

Sunday, April 25th, 2010

I’m getting lots of questions about why bank penalties have fallen in the last three weeks. This blog explains the calculation methodology behind it:

Transcript of Video Blog:

Hi, everybody. It’s Rowan Smith from the Mortgage Centre. I wanted to address penalties, and interest rate differentials, and three month interest penalties and how it all works today in this blog.
I’m getting a lot of inquiries about it. There’s some confusion as to why rates have gone up and penalties have gone down. Well, let’s look at the standard mortgage terms.

For variable rates mortgages, most institutions, the way that it’s going to work is if you break the term at some point during any time; now most variables are five year terms, but some of them are three years.

That means that during that period of time, your discount or your premium on your rate will not change. For example, if your rate was prime rate plus a quarter, for five years you would always be prime plus a quarter regardless of where prime went. Up or down, you would follow it with a quarter percent.

You’re guaranteed that, so should banks go with prime plus a half or prime plus one, you’re still guaranteed to retain the prime plus a quarter throughout that five year term.

In exchange for that security, if you break that term, that five-year term, to sell your house, or you need to refinance, take equity out and end up doing it with a different lender, you’re going to pay a three month interest penalty.

That said, it’s a non negotiable. It’s going to happen at every single institution. However, the three-month interest penalty is the only one that will apply to a variable rate mortgage. In the event that you’ve got a fixed rate mortgage, it will be the greater of three months’ interest or the interest-rate differential.

Interest rate differential is a complicated formula that essentially looks at how much time is left in your term, what rate you’re paying now, what rate the bank could get on money now, and they charge you that difference. That’s a simplification, or perhaps an oversimplification of it.

But if you visualize being at six percent, and let’s say rates went down to the 3.69 they were at and you wanted to get that rate, that bank would be giving up on six percent for the remainder of your five year term and letting you out into the lower term.

So they’re going to look at their loss/profit and are basically going to charge you that amount or three months’ interest, whichever is greater.

You can guarantee that in cases where rates have gone down, your penalty is going to be dramatically larger under the interest-rate differential. Now how far down? It depends. It’s a complicated formula.

How much time is left in your term? If you’re within the last year, it’s generally only ever three months’ interest. There are a lot of different variations in how these penalties can be calculated from bank to bank to bank.

So if you’re looking at your penalty, not quite sure if the penalty is worth paying it to get the new lower rates, give me a call and I can walk through the math with you on it and make sure that you’re making a correct decision.

Also, if you’re looking at that penalty and wondering why did the penalty go down from last month when I had a quote, it’s because rates came up. That means that the bank could get a greater rate from money loaned at the same point at time.

So if you were three years into a five year term, there are two years left. The bank will compare their profit and loss of what they would get on a two-year mortgage.

Imagine, for example, that rates have gone in two years from, let me grab a number here, 2.25 to 2.9. If you were previously paying five percent, that spread, the difference between what they could be getting and what they are getting, got smaller, thus your interest-rate differential penalty will be smaller.

As you can see, there’s quite a bit to penalty calculation. If you have any questions, give me a call. For the Mortgage Centre, I’m Rowan Smith.