Interest Rate Differential – The hidden cost of low interest rates.

Whatever happened to 3 months interest penalties?

We all know that interest rates are still at record lows, but how do you take advantage if you are currently in a fixed rate mortgage contract?  I’m sure you have heard horror stories of people being charged ten thousand dollars in penalties to break their mortgage contract – even as high as $12,000 to $15,000!

Many of your friends or family members may have been lucky enough that their mortgage renewal date has come up or where able to purchase while rates are at their all time low, but for many others who may be paying over 5% interest on their mortgage, breaking the mortgage contract early may be costly.   An Accredited Mortgage Professional will be able to help you determine if paying the IRD is worthwhile, by providing a Refinance Savings Analysis.

How IRD Came to Be

Back in the early 1990’s, mortgage penalties were capped at 3 months interest (for all CMHC insured mortgages) and most banks used this formula for calculating all their mortgages, including conventional mortgages.  In 1999 CMHC quietly removed the 3 months interest cap from their policy, likely because of competition from Genworth entering the marketplace (a competitor to CMHC).  Banks slowly changed their own policies to allow for IRD (Interest Rate Differential) to be charged, and today, we have banks using an unfair penalty calculation that does more than cover any potential loss.

The IRD penalty is to compensate the bank for any loss due to a mortgage being paid out and then having to lend the funds again for the remaining term at a rate that is less than what they had in your contract.

What’s Unfair?

Recovering loss on a contract is a reasonable request, however, the problem is that banks have been left to calculate IRD penalties whatever way they want (the formula is not uniform among all lenders or regulated by the Bank Act).  This means that some lending institutions have been overcharging clients in their IRD calculations.  Also, banks have shrunk their spread between posted and discounted rates causing borrowers to pay record mortgage penalties.

Have you noticed that 1, 2 and 3 year fixed term interest rates are unnaturally low – and have been for some time?  This does two things for banks – it increases the IRD penalty which helps retain customers in higher interest mortgages, and it also attracts new customers for short term mortgages (the new customers hopefully will renew at much higher rates in the future).

When it comes to calculating an interest rate differential penalty, lenders are doing what they like.  There is no standard formula, nor is there federal legislation or governing parties overseeing what the lenders are charging. And this has got to change.

Tips for fighting an unfair IRD penalty:

1.  Ask for a printed “information only” discharge statement for your existing mortgage.

2.  Check to see if the lending institution has applied the allowable pre-payment privilege to the discharge (this is the amount of pre-payment you can make – under contract – to be applied directly to your principal without penalty).  It is usually between 15 and 20% of the initial amount of the mortgage.  Using the pre-payment privilege will reduce the penalty by 15% to 20%.  This should be standard practice, but it isn’t.

3. Check the comparable interest rate used to calculate IRD.  Here’s where things get dicey.  Common practice is for the bank to compare your interest rate to their current interest rate for term closest to the months you have remaining in your mortgage.  For example, if you have had your mortgage for 3 years, 2 months, then the bank should be using their current interest rate for a 3 year term, comparing it to the interest rate you currently have.
Banks will sometimes use the lower rate at 2 years to compare (and make the IRD larger as the two year comparable rate will be lower than the 3 year comparable rate, increasing the “spread”).  Also, say you secured your mortgage at the bank’s then “posted” rate less .50% (not the lowest discounted rate the financial institution offered to the broker market).  It would be fair to compare the remaining term of the bank’s current posted rate less your initial discount of .50%, not the lowest discounted rate they give their “preferred” customers.  Instead, you will likely be at the mercy of the bank’s whim to calculate the IRD to their highest advantage, using their lowest discounted rate.

4.  Engage a third party firm to review your IRD penalty.  There are companies out there now who will engage the bank to fight unfair IRD penalties.  They charge a percentage of the recovered penalty, but can be very effective in saving you money.  To be most effective, you should engage them after you get a written payout statement, but before you discharge the mortgage.  An Accredited Mortgage Professional will be able to help you locate a firm to help you fight the IRD penalty.

5.  Write the government to evoke change.  There is no ethical justification for a financial institution to maximize profits on the backs of average Canadians by playing games with early renewal “penalties”.
In February of 2010, Federal Finance Minister Jim Flaherty announced in this budget he was bringing in legislation to make the early renewal penalties consistent among all Canadian financial institutions.  It’s now almost a year later and thousands of Canadians have been overpaying IRD penalties.   Why is it taking the Federal Government so long to do the right thing?

Our best advice is to not take the lender’s penalty calculation at face value.  Do not rely on what your financial loans officer’s calculation as to the penalty will be.