How your mortgage penalty is calculated: posted vs discounted IRD

Penalty formulas for fixed and variable rates

There are only 2 formulas, and which one applies depends on whether your rate is fixed or variable.

Variable rate: 3 months of interest. Take your current balance, multiply it by your annual rate and divide by 4. On $400,000 at 4.20%, that's $4,200. It's predictable and works almost the same way at every lender in Canada.

Fixed rate: 3 months of interest or the interest rate differential (IRD), whichever is greater. When rates are falling, the IRD is almost always the larger of the 2, and that's where the problems come from.

The variable-rate penalty is small and easy to work out, and the fixed-rate penalty is neither. Weigh that when you choose between fixed and variable.

How an IRD penalty is calculated

The interest rate differential is meant to make up for the interest the lender won't earn once you leave. In principle, it's 3 numbers multiplied together:

Your balance × the rate difference × the months remaining in your term.

You know your balance, and you know how many months are left. The rate difference is the problem. It's the gap between your rate and a comparison rate, and the lender decides what the comparison rate is.

Here's an example. Say you have a $400,000 balance and 3 years left on a 5-year term, signed at 5.09%.

If the comparison rate is 4.09%, the differential is 1.00%. $400,000 × 1.00% × 3 years comes to about $12,000.

If the comparison rate is 2.59%, the differential is 2.50%. The same math gives you about $30,000.

It's the same mortgage, on the same day, with the same time left. The $18,000 difference comes entirely from which comparison rate the lender uses.

The posted-rate method

Most of the big banks use this method, and it produces the large penalties.

It works in 3 steps:

1. Find the posted rate for the term closest to the time left on your mortgage. Posted rates are the bank's advertised list rates, and they're well above what borrowers pay.
2. Subtract the discount you got when you signed: the gap between the posted rate at the time and the rate you received.
3. Compare that adjusted rate with your contract rate. The gap is the differential.

Step 2 is what drives the penalty up. If you negotiated a big discount off the posted rate when you signed, that same discount now comes off today's posted rate. That pushes the comparison rate down and widens the differential.

So, counter-intuitively, the better the discount you negotiated at the start, the larger your penalty can be. It's all in the mortgage documents, it's legal and it's disclosed. It just rarely gets explained at signing.

The discounted-rate method

Monoline lenders and most credit unions, including Alberta's, generally calculate it differently. They compare your contract rate with the rate they're offering today for the term closest to your remaining term. That's a rate a borrower could get today, not a posted list rate.

There's no discount adjustment and no posted rate, so the differential doesn't get wider. The comparison is like-for-like, and the penalty comes out much smaller.

In the example above, the 2 methods were $18,000 apart on an ordinary Alberta balance. On many mortgages, that's more than the total rate saving that made the mortgage appealing in the first place.

We don't single out individual lenders here. Both methods are legal and both are disclosed. The difference between them can be worth more than the rate difference you spent a weekend shopping for.

What to do if you're facing a large penalty

First, ask your lender for the exact figure in writing. Calculators, including ours, only give you an estimate. The written payout quote is the number to plan around, and it's usually only valid for a short time.

Then work through your options, roughly in order of how often they help.

Wait, if you can. The IRD shrinks as your remaining term gets shorter, because there are fewer months to multiply. In the last few months of a term, it usually drops to the 3-months-interest minimum. If you're 11 months out and your plans are flexible, waiting is often the cheapest option.

Use your prepayment privilege first. Most lenders let you prepay a lump sum of 10% to 20% of the original principal each year, and then calculate the penalty on the lower balance. Doing both in the same transaction, in that order, can cut the penalty by the same proportion. Check with your lender first, since not every lender allows it.

Ask about a blend-and-extend. Your current lender blends your rate with a new one over a longer term. You avoid the penalty because you aren't breaking the mortgage, but the penalty is effectively built into the blended rate. It can still be the best option, and only your current lender can offer it.

Port the mortgage. If you're moving, porting takes your rate and term to the new property and avoids the penalty entirely. Check the porting window (most lenders allow 30 to 120 days between the sale and the purchase), and check that your mortgage is portable at all.

Work out the break-even. If you're breaking the mortgage for a better rate, divide the penalty plus costs by your monthly saving. That's your break-even in months. If it's shorter than the time you'll keep the mortgage, breaking pays. If it's longer, it doesn't.

How to avoid a large penalty next time

Each of these is a decision you make at signing, and none of them costs anything at that point.

• Ask which IRD method the lender uses, and weigh it alongside the rate. A quarter point of rate is worth a few thousand dollars over 5 years. The penalty method can be worth tens of thousands on a single break.
• Choose a term that fits your plans. A 3-year term you keep beats a 5-year term you break. The rate difference between them is almost always smaller than an IRD.
• Check portability and assumability before you sign, especially if there's any chance you'll move.
• Avoid restricted no-frills mortgages unless you're sure you'll keep them to maturity. Some have a bona fide sale clause, which means there's no penalty you can pay to leave. The only way out is to sell the house.
• Keep your paperwork. Your original commitment shows the posted rate at signing and the discount you got. If you ever need to check a penalty calculation, that's your evidence.

If a penalty quote doesn't look right, ask the lender to show you the calculation. They're required to be able to explain it, and math errors on payout statements happen more often than you'd think.