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Mortgage Penalties Exposed

To do this we need to go back in time… in the 1990′s, mortgage penalties were capped at 3 months interest (for all CMHC insured mortgages)…This was a policy that CMHC had implemented.  Most banks just used that same formula for non-cmhc insured mortgages….some Banks still had an IRD penalty clause in their standard charge terms but the formula for calculating this was very different from today.

Back then, a few things were different…  Discounted rates on 5 year terms were only 0.50% to 0.75% off Bank Posted rates… if you had 3 years remaining in your 5 year term, the banker went to the rate sheet, looked at their 3 year POSTED fixed rate and if your rate was higher, then they calculated the IRD (usually, a nominal amount because the banker only had posted rates to compare with).  If your rate was lower, then the banker could impose a 3 month interest penalty or NO PENALTY.. that’s right, no penalty.  It was up to the banker’s discretion. 

The reason or justification for having an IRD penalty in the first place is to compensate the Bank for any loss that they may incur when re-lending the funds…

Let’s fast forward to the end of 1999.  CMHC quietly removed the 3 month interest penalty cap from their policy…probably because of competition from Genworth Financial Mortgage Insurance (formerly GE Mortgage Insurance and a competitor to CMHC). 

HERE’S A DIRECT QUOTE FROM THE TD CANADA TRUST WEBSITE: (not to single out TD because most banks are the same)

“The IRD amount is calculated on the amount being prepaid using an interest rate equal to the difference between your existing mortgage interest rate and the interest rate that we can now charge when re-lending the funds for the remaining term of the mortgage.”

Did anybody get that?   The IRD penalty is there to compensate the Bank for any loss due to a mortgage being paid out and then to have to lend funds out again for the remaining term at a rate that is less than what they had in the contract. We don’t think anyone would have a problem with that.  After all, it is a business and they can’t be expected to take a loss.  

But somewhere along the line, this reason got lost or forgotten. The Bank’s recently have shrunk their spread between posted and discounted rates causing borrowers to pay record mortgage penalties.


Let’s look at the numbers..  Let’s use a $200,000 mortgage that was taken out in December 2008 at 5.54% for a 5 year fixed term… The Posted rate was 6.95% giving us a discount of 1.41% off the 5 year fixed rate.  Using a 3 year posted rate of 4.15%.   (we’re using TD Canada Trust in this example because they have a clear explanation and formula on prepayment penalties on their website…but this formula is similar to what the other Big Six banks are using.)

Using the IRD formula from their website the penalty would be approximately $16,800.  That’s equal to 18 months of interest!!  Here’s what’s happening.  The Banks are using your original discount given at the time of the mortgage.  They take that discount, in this case, 1.41%, and subtract that from their posted 3 year fixed rated (4.15% – 1.41% = 2.74%).   The problem is that NONE of the Big Six Banks are advertising a 1.41% discount off their 3 year rate…  The best advertised rate that we could find with TD Canada Trust was through their Broker channel.  That rate was 3.60%.   So why are they using 2.74% to calculate your IRD penalty? That reduced posted rate is costing borrowers dearly.  And to put this in a better context, if the posted 3 year fixed rate was 1.30% higher than the discounted rate today, then the penalty would be approximately $11,640 instead of $16,800 .  (as an aside, if this was 1998, your penalty would cost $8,340 because the Bank only used the Posted Rated when calculating the penalty.)

End result is HIGHER MORTGAGE PENALTIES for borrowers.

We need to get more attention on this subject.  These penalties are unfair, unjust and the logic isn’t adding up to the original reason for having mortgage penalties to begin with.  Hoping this article explains the HOW penalties are calculated…. We’ll let you figure out the WHY they are calculated this way… we think it’s quite obvious who is winning and who is losing.  

Posted: Sunday, January 23, 2011 8:38 AM by OUR TOWN REALTY LIMITED
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