Lower your IRD mortgage penalty

Sam Taylor loved helping people which is why she started her career as a social worker. But after almost three decades, Sam was burnt out and needed out. After a great deal of soul-searching she decided to start her own home staging business. “Over the years more and more people have asked for my help,” she explains. “I have a flare for it.” To start and grow her own business, however, she needs capital. To get capital she needs to sell her home—and that means breaking her fixed-rate mortgage.

What Sam found out shocked her. She was on the hook for almost $18,000 in fees, as a penalty for breaking her mortgage early. Turns out, breaking up (with your mortgage) really is hard to do. And Sam was lucky. According to the Financial Post, Tyler Bollhorn, a personal finance author who decided to move from Kelowna, B.C. to Hawaii, was shocked when he learned he’d have to pay more than $150,000 to break his mortgage. “I got stuck with a pretty good penalty because I never read the fine print,” he says.

Turns out, Taylor and Bollhorn aren’t the only ones caught paying big fines to break their mortgage. Steve Garganis, an independent mortgage broker and editor of CanadaMortgageNews.ca, ends up talking to many Canadians shocked to learn about the exorbitant fees to break a mortgage term. “I just spoke to a commercial banker who went through a separation and divorce just two years into his mortgage. He ended up paying $34,000 to get out.”

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Why the penalty?

Most mortgages have a fee to exit the contract. The reason for the penalty is to compensate the lender for the loss of expected profit and to compensate for the costs of creating and breaking a mortgage. This is just as important for investors as it is for mortgage-holders.

Say, for instance, you own RBC or CIBC stock; the value of this stock goes up and down based on the balance sheet of those banks. One of the primary ways the balance sheet rises is when lenders charge interest on the loans they provide to borrowers. If a borrower promises to borrow money for five years, the bank counts on five years of interest payments. Reneg on that deal, and the lender needs to recoup some of that loss revenue.

How is the penalty charged?

Generally, the penalty is the larger of two calculations: three months’ interest or a formula known as the Interest Rate Differential (IRD). Typically, if a homeowner breaks their variable rate mortgage, the penalty is equivalent to three-months’ interest. So, if 50% of your $2,000 monthly mortgage payment goes to paying interest, you’d be charged a penalty of roughly $3,000 to break the mortgage (plus any discharge or administration charges, which can also add up). But if you had a fixed rate mortgage, the IRD is used. The issue is how this penalty is calculated and, for the most part, each lender has a slightly different variation.

Why is the IRD so expensive?

Since there is no standardized approach to calculating the IRD and considering that mortgage contracts are often unclear and vague, a few homeowners have begun to push back on the high penalties charged for breaking a mortgage. In 2014, a class action lawsuit was launched against CIBC regarding “vague” wording and “inappropriate” calculations. According to the lawyers, more than 52,000 Canadian homeowners could be eligible for refund cheques if the lawsuit succeeds.

But putting the vague wording aside, Garganis points to another problem: how lenders treat a discounted rate when processing a penalty. Apparently, some lenders will include the money you saved by going with a discounted rate and add it back into the formula when calculating the penalty. So, if you may have negotiated a five-year fixed-rate mortgage at 2.99%, but the penalty for breaking that mortgage may actually be based on the posted rate, which currently sits at 4.64%.

It’s the equivalent of having to pay back your discount because you broke your contract. To appreciate how this works, consider a gym membership. Let’s say the regular rate is $50 per month, but you negotiate a rate of $20 per month. Eight months later you need to move, so you cancel your gym contract. The gym not only charges you $200 as a penalty—the four remaining months owed—but also charges you the $240 you saved over the eight months while paying the discounted gym membership.

“That just seems unfair to Canadian homeowners,” says Garganis.

But didn’t the rules change?

If you seem to recall a media frenzy about massive IRD rates and talk from the federal government to do something about it, then you’re right. In late 2011, the federal government began to poke around in the mortgage penalty regulation space. There was a great deal of talk about changing the IRD formula—making it standardized, or at least, easier to understand—but nothing came of this, explains Garganis. “Lots of mortgage rules have changed since the subprime mortgage crisis of 2008, but not mortgage penalty formulas.”

The consensus among politicians and bankers is that “any change [to the formula] was too difficult to implement.”

But this wasn’t the first time politicians tried to tackle this thorny issue. In 1999/2000, the Canada Mortgage and Housing Corporation introduced a cap on how much lenders could charge in penalty for early mortgage payouts, explains Garganis. But this cap restriction was lifted fairly quickly and, since then, lenders have gone back to applying their own penalty formulas.

Ask Home Owner columnist Romana King your real estate question »

What to do if you need to break your mortgage

Where does that leave the homeowner? “Remember the squeeky wheel?” asks Garganis. “Well, it really does get the grease.”

To help here’s a checklist of six tools to use:

No. 1: Do a bit of daydreaming

If you haven’t yet chosen your next type of mortgage, it’s a good idea to consider where you will be in five years. What about three years? By assessing how your life may change over the term of the mortgage you can make better mortgage decisions on the outset. If, for instance, you’re facing any uncertainty, consider opting for a variable-rate product. The penalty to break these is a relatively simple equation: just three months’ interest.

Another option would be to consider porting your mortgage, rather than breaking it. Basically, you apply your current mortgage to your new home. There’s no prepayment charge, although if you reduce or add to the mortgage amount, you would have to pay a penalty. Also, this option only works if you’re moving within Canada.

No. 2: Shop around

Whether you opt for variable or fixed, consider shopping around. When comparison shopping don’t just focus on rate, but consider how penalties are calculated and if you have prepayment benefits.

No. 3: Think small

Quite often we get caught up in brand recognition—whether or not we’ve heard of the bank or lender. But some of the most active and stable lenders in the Canadian mortgage market aren’t spending money advertising—nor are they worried about becoming a name-brand. “They work with independent mortgage brokers and, quite often, offer more competitive rates,” says Garganis. Even better, these lenders—known in the industry as mono-lenders—will have less expensive penalties.

No. 4: Do the math

If you’re opting to break a mortgage to get a better rate, then you need to do the math. Call your lender and ask them to calculate the penalty to break the mortgage today (most can’t do future projections, but you can get a good ballpark if you ask them to calculate the penalty as if you’re were breaking the mortgage contract today).

Then consider all the other charges for breaking the contract. For instance, there’s usually a discharge fee that ranges from a low $150 to a high of $1,000, if you have a collateral mortgage. A collateral mortgage is registered as a type of lien under the Personal Property Security Act (PPSA) of Canada and requires more legal work to be discharged. Collateral mortgages can be good if you plan on taking out an Equity Line of Credit or if you plan on staying with the same lender in the future, but will cost you more if you need to break your mortgage or transfer to a different lender in the future.

Once you have all the costs, add them into your calculations. This is where you get to see how much it will really cost you to break the mortgage.

No. 5: Cut the costs with prepayments

Quite often your mortgage contract will allow you to make a prepayment—a lump sum payment against the principal. By taking advantage of prepayments, you can lower your loan, which should lower your penalty. Talk to your mortgage advisor or lender to confirm how a prepayment will impact the penalty charged to break the contract early.

Here’s more tips on how to Crush Your Mortgage »

No. 6: Start complaining

Even if you’re financially prudent, very often life just happens; usually it’s a personal matter that drives this situation. If that’s your case, you may find some solace in the fact that less than 50% of mortgages are actually kept to maturity. But you still have one last tool in your arsenal: start complaining. Speak to the bank manager, then the VP, then try the ombudsman. If that fails, consider getting some cardboard and making a placard. Nothing says unfair like: “I have to pay $30,000 to break my mortgage, so I can sell my home after my divorce.”