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Breaking your Mortgage? Know the Rules

Breaking your Mortgage? Know the Rules
By Ellen Roseman
www.moneyville.ca

Mortgage rates are falling. You want to break your closed mortgage and get a new five-year loan at 2.99 per cent.

Hold on. Take a deep breath. Talk to your lender first.

Find out how much you will have to pay to get out of your mortgage early. The penalty could wipe out all your profit on the deal.

Mortgage penalties come as a big surprise to borrowers who aren’t prepared for them. Banks are often unprepared as well, since the information is buried in the fine print of a mortgage contract.

As a result, bank employees don’t give accurate quotes to customers who want to leave a closed mortgage before the term expires.

Vanessa had four years left on a $300,000 mortgage when she sold her home last year. She went with another bank to get a better rate, rather than porting the existing mortgage to her new property.

“When I called to find what the penalty would be to end my contract,” she says, “I was told it would be three months’ interest (equivalent to $2,600). Nothing was said about the IRD.”

Most closed fixed-rate mortgages have a prepayment penalty that is the higher of three months’ interest or the IRD or interest rate differential. Most variable-rate mortgages do not have IRD penalties.

Only after the sale did Vanessa learn she’d paid an IRD penalty of $15,000. It was based on the bank’s posted rate when she took out the mortgage — and not the discounted rate she had actually received.

I’m not against the IRD. I believe lenders should be compensated when borrowers make an early exit at a time of falling rates.

However, I’m against the inconsistent way that lenders calculate the IRD. They can plug in their own numbers to decide how much money is at stake when a closed mortgage is opened up.

Luckily, banks will have to give more disclosure under a new federal code of conduct that comes into effect by November of this year.

They’ll have to tell you how prepayment charges are calculated and how you can pay off a mortgage more quickly without incurring penalties.

The IRD is based on (1) the amount you are prepaying and (2) An interest rate that equals the difference between your original mortgage rate and the rate that the lender can charge today when relending the funds for the remaining term of the mortgage.

Robert McLister, a mortgage planner, has a mortgage penalty calculator at his website that gives you a rough estimate of what you may be charged.

“Some lenders don’t use the discount you received in your calculation, which decreases the IRD and can lower your penalty considerably,” he says.

“Some lenders round up your remaining months to the next longest term. Some round down.”

Suppose you have 18 months left on your mortgage term. Lenders can use the posted rate of their two-year term as the comparison rate. But they can also use the one-year posted rate.

Lenders may not advise you to use your existing prepayment privileges. Most mortgages let you prepay 10 to 20 per cent of the balance each year without incurring a penalty.

By making a prepayment, you can reduce the outstanding balance subject to the IRD when you’re refinancing.

Vanessa wasn’t offered a chance to make a lump-sum payment before discharging her mortgage. She was reimbursed for $2,500 of the penalty when she appealed to the bank’s ombudsman.

Here’s another case of a borrower not being given the right information. Sarah Rigley MacDonald decided to break her existing mortgage, which had a 10-year term, when buying a new property.

Her mortgage broker said her prepayment penalty would be $10,000 — but didn’t say the penalty would go down to $1,600 after the five-year point of her 10-year term.

The federal Interest Act prohibits IRD penalties on terms over five years, after five years have elapsed. In such cases, a maximum three months’ interest penalty may apply.

“Now we’ll sit tight until our five-year anniversary, just 16 months away, and look at our options,” she said. (The Interest Act information, which she found at my blog, saved her thousands of dollars.)

In a previous federal budget, Finance Minister Jim Flaherty promised to give more clarity about mortgage penalties. He also suggested the calculations would be standardized.

Standardization was not part of the reform package that Ted Menzies, minister of state for finance, unveiled last month. Instead, the focus was on providing more information to borrowers.

“Disclosure must be made in language, and presented in a manner, that is clear, simple and not misleading,” the code of conduct specifies.

Federally regulated financial institutions must start to address the guidelines by May 7. They must be in full compliance by Nov. 5 of this year.

Lenders will provide prepayment advice on annual mortgage statements. They’ll supply website calculators to help you estimate the mortgage penalty you may be charged.

They’ll set up toll-free lines to reach staff members who can give you a written statement of prepayment charges if you ask for it.

Finally, lenders won’t take steps to pay out your mortgage until you assent to the penalty that will be charged.

I still wish there were guidelines on how penalties are calculated. But I know the Harper government believes in letting market forces prevail and giving consumers an informed choice.

Now it’s up to borrowers to manage their prepayments in a way that reduces the penalty shocks that can arise when refinancing.