How Are Mortgage Penalties Calculated?
Sample Mortgage Details
These are the details of the mortgage we will use in our sample calculations.
5 year term, 3 years remaining, interest rate is 2.89%, $250,000 left owing on mortgage, current fixed rate offered on a 3 year term by lender 2.39%, 5 year posted fixed rate 4.64%, 3 year posted fixed rate 3.44%.
These are the details of the mortgage we will use in our sample calculations.
5 year term, 3 years remaining, interest rate is 2.89%, $250,000 left owing on mortgage, current fixed rate offered on a 3 year term by lender 2.39%, 5 year posted fixed rate 4.64%, 3 year posted fixed rate 3.44%.
Variable Rate Mortgage Penalty Calculation - 3 Month's Interest
Calculate the annual interest amount by multiplying the remaining mortgage balance by the annual interest rate: $250,000 x 2.89% = $7225
Calculate the monthly interest cost by dividing the annual interest amount by 12: $7225 / 12 = $602.08
Multiply the monthly interest cost by 3 to determine the penalty: $602.08 x 3 = $1806.24
**Most 3 month interest penalties are calculated this way, however, some lenders use an inflated interest rate to calculate the penalty. Be sure to get clarification on how the penalty is calculated before signing the contract.
Fixed Rate Mortgage Penalty Calculations - Greater of 3 Month's Interest or Interest Rate Differential (IRD) Penalty
3 Month's Interest Penalty
3 Month's Interest Penalty is the same as above = $1806.25
Interest Rate Differential Penalty (IRD)
There are 3 main ways that Lenders calculate IRD Penalties and it's important that you understand which method is being used on the mortgage you are considering signing before you sign it. As you will see in the examples below, the different method can have a huge affect on the amount of the penalty.
**For the examples below, we are using a 5 year fixed rate mortgage.**
Standard IRD Calculation
First, calculate the spread between the actual mortgage interest rate and the interest rate offered by that lender on the term closest to the time remaining on the mortgage contract: 2.89% - 2.39% = .50%
Calculate the annual IRD penalty amount by multiplying the remaining mortgage balance by the interest rate differential or "spread": $250,000 x .50% = $1250
Calculate the total penalty by multiplying the annual IRD penalty by the number of years remaining on the mortgage: $1250 x 3 = $3750
Discounted Rate IRD Penalty Calculation
This method involves what's known as a posted rate. Banks and Trust companies advertise posted rates on their websites which are significantly higher than the rates they actually give their clients. You can find out what each banks posted rates are by visiting their websites. For this example, we will assume that the posted rates are:
5 year fixed posted rate = 4.64%
3 year fixed posted rate = 3.44%
First, calculate the discount off of the posted rate that was given: 4.64% - 2.89% = 1.79%
Calculate the discounted rate to be used in the penalty calculation by subtracting the discount from the posted rate on the term most closely matching the remaining term of the mortgage: 3.44% - 1.79% = 1.65%
Calculate the penalty rate by subtracting the discounted rate from the actual mortgage interest rate: 2.89% - 1.65% = 1.24%
Calculate the annual penalty amount by multiplying the remaining mortgage balance by the penalty rate: $250,000 x 1.24% = $3100
Calculate total penalty by multiplying annual penalty amount by the number of remaining years: $3100 x 3 years = $9300
Posted Rate IRD Calculation
This method also involves posted rates. It is quite simple but not cheap.
First, calculate the penalty rate by subtracting the actual mortgage interest rate from the posted 5 year fixed rate: 4.64% - 2.89% = 1.75%
Calculate the annual penalty amount by multiplying the amount left owing on the mortgage by the penalty rate: $250,000 x 1.75% = $4375
Calculate the total penalty by multiplying the annual penalty amount by the numbers of years remaining on the mortgage: $4375 x 3 years = $13,125
As you can clearly see, the difference in the way the Interest Rate Differential Penalty is calculated can mean the difference of thousands of dollars. Because of this fact, it is very important that you pay attention to this calculation when choosing a mortgage.
Monoline Lenders as well as most Credit Unions commonly use the Stardard IRD Calculation whereas the "Big 6" Banks most often use either the Discounted Rate or Posted Rate Methods as they are much more profitable for them.
