The Hidden Trap of Mortgage Penalties

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A couple of weeks ago I had a client tell me that his bank advised him that all banks calculate penalties the same way. Well although on the surface banks will use similar methods to calculate the penalty. What differs is what rates they use to determine the penalties. Many don’t realize this but virtual lenders have a very different approach to penalty calculations then the big banks do. The following is an article from the Globe and Mail that explains this point better than I can.

December 4, 2013
The hidden trap of mortgage penalties
By ROB CARRICK

Find out whether the lender uses posted rates to calculate what you’d have to pay to break your contract. Knowing this upfront could save you thousands

It’s easy to get caught in the posted mortgage rate trap at the big banks.No, you won’t have to pay the posted rate on your next mortgage. Pretty much nobody does that anymore, according to mortgage broker Robert McLister. The real danger is that posted rates will be used to calculate the penalty if you ever have to break your mortgage, probably costing you thousands of extra dollars.A mortgage penalty compensates a lender for the interest payments it loses out on when you break a mortgage contract.

“That’s the intention,” said Mr. McLister, who is also the editor of CanadianMortgageTrends.com1. “But in many cases, it overcompensates. It’s punitive in many cases.”As we head into another round of quarterly bank earnings reports, it’s worth thinking for a moment about how those wonderful profits and dividends for investors are generated. One way is by using posted instead of lower discounted rates when calculating how much to penalize a client breaking a mortgage.With houses as expensive as they are today, it’s crucial to get the lowest mortgage rate you can. Keep the same level of focus when inquiring about mortgage penalties.

Although it’s hard to imagine the need to break a mortgage on a house you’re just buying or living in happily, it can happen. Mr. McLister said roughly 70 percent of people adjust their five-year fixed rate mortgage before maturity, although many do it to refinance or move to a bigger house rather than to break the mortgage outright. Mortgage penalties are straightforward if you have a variable-rate mortgage – expect to pay the equivalent of three months’ interest in most cases. With a fixed-rate mortgage, the penalty is set at the higher of three months’ interest or a calculation called the interest rate differential, or IRD. The must-ask question when negotiating a fixed-rate mortgage:

Do you use discounted or posted rates to calculate these penalties? This is important because using posted rates can result in a much higher penalty. For some real-world numbers, let’s use the mortgage prepayment calculators all lenders now provide on their websites. They show penalties for paying all or a portion of your remaining mortgage balance (to find them, Google your lender’s name and “mortgage prepayment calculator”).Let’s use an example of someone who, three years ago, set up a $250,000 five-year mortgage and has a balance owing of $200,000.

Assuming an original mortgage rate of 3.64 percent with a discount of 1.5 percentage points, the mortgage prepayment calculators at several big banks showed penalties ranging from $5,000 to $7,600 or so. A check with some alternative lenders found penalties ranging from $1,800 to $2,800. These are very rough comparisons because lenders differ a fair bit in what information they ask you to supply. But you get the picture – the big banks apply penalties with a sledgehammer. As well as producing revenue for lenders, inflated mortgage penalties also help trap clients who might otherwise move their business to another lender. Imagine you want to refinance your mortgage or buy a bigger home and your bank won’t come across at a competitive rate. You say you’ll change banks, only to find out how prohibitively expensive it is to break your mortgage.

Mr. McLister said some banks have a stated policy of offering clients only a small discount off the posted rate if they want to add on to their mortgage to buy a more expensive house. You may be able to negotiate something better than a trivial discount, but your bank knows your leverage is limited because of the penalty you face if you go. Alternative lenders often have better rates than the big banks, and they typically have cheaper penalty fees. Why do so many people use their banks for mortgages, then? Mr. McLister speculated that some borrowers like the convenience of having their mortgage where they bank, and of being able to go into a branch to talk about their mortgage. If you prefer transacting online, some alternative lenders don’t have great websites. One thing you do not need to worry about if you borrow from an alternative financial institution is that your lender will go bankrupt. ‘it’s funny that people look at mortgages and think, I need a safe lender.’ Mr. McLister said. ‘If a lender goes out of business, pretty much nothing is going to change except for the name of your new lender.’

If you have questions about this or any other matter pertaining to real estate or Mortgages please do not hesitate to contact me at 514-680-4674

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