What Is a Mortgage Penalty? Early Termination Fee? Prepayment Penalties?
Regardless of what they’re called, be aware to avoid paying them!
You may not realize it, but when you sign on the dotted line of a mortgage contract, you are agreeing to pages and pages of terms and conditions. For example, the CIBC Set Of Standard Charge Mortgage Terms from 2009 has 31 pages of terms and conditions. Many of what is written in these 31 pages would not be understood by many of the clients who sign documents like these each day. While law states that a contract can only be binding if both parties understand and agree all terms, homeowners across Canada are stuck in these very contracts with little knowledge of what lurks throughout. If you take some time to read through them, you are sure to find the words mortgage penalty, early termination fee, or prepayment penalty somewhere in the lengthly document!
Standard Charge Mortgage Terms – Not An Easy Read!
All contracts, including mortgage contracts, are written by lawyers using language which is very difficult to understand for those of us without a degree in law. While the big banks and lenders claim that the lengthly contracts and wordy sentence structure is to cover their bases, some would suggest that it is simply to increase the potential for borrowers to violate terms and conditions and pay a mortgage penalty – also referred to as a mortgage termination fee, or mortgage prepayment penalty. The very difficult to understand and unclear terms and conditions in the 2009 Standard Mortgage Terms earned CIBC a class action lawsuit by Siskinds LLP in October 2011 for the following:
“A class action was commenced by Siskinds LLP in October 2011 against CIBC Mortgages Inc. regarding its practices for calculating a prepayment penalty on mortgages entered into across Canada since 2005.
The Statement of Claim alleges that CIBC applied terms and conditions to certain mortgage contracts to allow it unfettered discretion for calculation of a prepayment mortgage penalty. It if further alleged that the quantification of prepayment penalties applied by CIBC are in breach of the mortgage contracts.
The action applies to CIBC mortgages as well mortgages through related entities such as Firstline Mortgages and President’s Choice Financial.”
Read the entire press release here.
Understand Your Mortgage Penalty & Early Termination Fee Upfront
Most homeowners approach mortgage brokers and big banks seeking the mortgage with the best rate. In many cases, once a reasonable rate is found, borrowers simply agree and sign without paying attention to the details of their great mortgage “deal.”
While a great rate can make you feel like you have won the lottery, you may be robbing yourself in the long-run if you ignore the details of prepayment mortgage penalties and early termination fees. If your future plans involve actions which may require you to get out of your mortgage early, you may end up paying more in penalties than you would have saved with the great rate you found.
Common Prepayment Mortgage Penalties & Early Termination Fees
Most Canadian mortgage lenders will charge borrowers who pay their mortgage off early by charging the greater of three months interest or the interest rate differential as a mortgage penalty.
The Three Months Interest Mortgage Penalty
To calculate a prepayment mortgage penalty based on three months interest, the lender will take the amount which was paid off early and calculate the interest they would have earned over three months. This can be computed by multiplying the amount prepaid by the annual interest rate currently in effect for the mortgage and dividing by 4, since 3 months is equal to a quarter of a year.
For example: If you are paying 5% interest on your mortgage and your mortgage penalty is three months interest for a $100,000 prepayment, you would be charged:
$100,000 x 0.05 / 4
= $5,000 / 4
A $1,250 penalty is a hefty sum to pay for getting out of your mortgage early, but you could pay more if the interest rate differential is calculated to a larger amount!
Interest Rate Differential Mortgage Penalty
To calculate a prepayment mortgage penalty based on the interest rate differential, the lender will take the difference between the interest rate currently in effect for the mortgage and the lender’s current posted rate for the length of time remaining in your mortgage term. The result is the interest rate the lender will apply to the remaining length of time on your mortgage.
For example: If you are paying 6% interest on your mortgage and you are penalized the interest rate differential for a $100,000 prepayment with 4 years remaining in your term with the lenders current posted 4-year rates at 3%, you would be charged a penalty of:
$100,000 x (0.06 – 0.03) x 4
= $100,000 x 0.03 x 4
Typically, the interest rate differential will yield a higher prepayment penalty if an amount is prepaid with a significant amount of time left in the term and if posted rates are lower than the current rate of the existing mortgage. If current posted rates are higher than your current mortgage interest rate, it is in the lenders best interest to let you prepay to allow them to reinvest (aka lend) elsewhere at a higher rate.
While there are other types of mortgage penalties and early termination fees out there, it is almost standard that the higher of three months interest or the interest rate differential are in your mortgage terms and conditions.
Do Your Homework & Think Long-Term Before Signing
Like any contract, you should some research and think a few years into the future before agreeing to lock-in to a mortgage – especially mortgage terms longer than 5 years. If your future in a particular location is uncertain or you feel you may want to downsize before the end of a mortgage term, maybe you should stick to mortgages with shorter terms. If you are fairly confident that you are going to stay put in that particular home or would consider upgrading to a more expensive home, check your portability terms and explore your options for a longer term.
Regardless of what your mortgage situation, be sure to consult a professional before making any long term financial decisions. At times, it can still be beneficial to pay a mortgage penalty to receive a lower interest rate and take on a new mortgage. Hussein Saad, your Mortgage Centre Specialist is available via email or phone to help you determine what mortgage product is right for you and your family. Contact us today!