Borrowers beware. Your bank may charge you a five-figure penalty to take an early exit from a five-year mortgage.
The penalty is based on the difference between the fixed rate for your mortgage and the current five-year fixed rate until the end of your term. This is called the “interest rate differential,” or IRD.
The IRD penalty is a surprise to many borrowers, who think they will only be charged a penalty of three months’ interest (let’s call this TMI for short).
What do you need to know?
Why is there such confusion about mortgage penalties?
Most contracts are written in a similar way: The mortgage borrower will pay either a TMI or an IRD penalty, whichever is higher.
Interest rates were stable for a long time. But things changed after the U.S. financial crisis in 2008, which led to a worldwide recession and dramatically lower interest rates. The economic recovery was so weak that central banks kept their rates low.
As a result, the IRD penalty has become standard and the TMI penalty is rarely used. Moreover, the IRD can be much bigger than the TMI — up to five times higher.
The exception is when you have a CMHC-insured mortgage with a 10-year term and you have passed the fifth year. In such a case (which is unusual), the IRD penalty is not allowed.
Banks are supposed to use plain language when telling you the cost of cancelling a fixed-rate mortgage. If they did their job properly, I wouldn’t get as many complaints about IRD penalties as I do.
Can you give an example?
Yasmin Hussain had a five-year mortgage at 2.99 per cent with TD Canada Trust. She called the bank to see what it would cost to pay in full before the due date and was told there would be a TMI penalty of $5,746.
“I listed my house and sold it. Then, the branch manager said there would be an IRD penalty of $26,000,” she said.
“This was shocking news. I am retired and in debt. I sold my house hoping to clear my debt from the sale proceeds. If TD had given me the correct information, I could have easily rented my house and waited for the expiry date of the five-year fixed rate period.”
After Hussain wrote to the media, TD agreed to let her pay the originally quoted IRD penalty of $5,746.
How about another example?
Steve Hornett and Laura Robertson hoped to break a five-year CIBC mortgage to pay off debts and renovate. Robertson went to the CIBC website for information on prepayment penalties and was led to a calculator for working out three months’ interest.
After doing research on the TMI penalty, the couple met with their CIBC financial adviser at a Kitchener branch. Nothing was mentioned about the penalty being calculated in a different way.
They learned of a much larger IRD penalty only days before a refinancing deadline. They had little choice but to cancel the deal with another lender.
“CIBC confirmed we were misinformed by our financial adviser,” Hornett said, thanking me for getting involved. “It will provide a letter of apology and cover additional appraisal and legal costs.”
What advice can you offer when dealing with banks?
Ask how the mortgage-breaking penalty is calculated. Don’t assume you will pay three months’ interest.
If there is an IRD penalty, ask how much it will be. Ask at the beginning, and again closer to the date when you refinance or sell your home, because the penalty changes as interest rates change.
Ask for a mortgage specialist. Don’t rely on branch staff to give accurate estimates of IRD penalties.
Make a lump-sum payment to lower the balance, or simply wait until the end of your five-term term when you can pay in full without triggering any charges.
The Financial Consumer Agency of Canada has an excellent guide, Mortgage Prepayment: Know your Options.