When you have a fixed rate in place on your mortgage and your looking to do a mortgage refinancing either to acquire additional funds and/or get a better interest rate, you are likely going to be subject to some type of prepayment penalty.
A prepayment penalty exists in the first place to basically protect the lender against loss. For residential home mortgages or any commercial mortgage at say 5%, the lenders cost of funds may be 4% as an example (purely hypothetical to make the math simple), providing them with an operating margin of 1% (5% – 4%) to cover their operating costs and hopefully produce a profit.
Because your funds are locked in at 5% for a period of time, the lender also locks in their cost of funds for the same period of time. If the mortgage is prepaid and the lender is stuck at funds at a cost of borrowing that they can’t mark up due to current market rates, then they can potentially incur a loss on the overall mortgage transaction.
If you try to pay out the mortgage early, they have the right to charge a prepayment penalty which is typically the greater of three months interest penalty, or interest differential.
If rates are higher when you go to payout the mortgage, then isn’t likely going to be an interest differential penalty to consider.
Interest differential in simplest terms would represent the 5% interest rate on your old mortgage, minus the lenders current market rates for the time left on your mortgage, multiplied against the principal outstanding.
But that would be in simplest terms.
In reality, there can be considerable structural differences in how the interest differential is calculated by the lender. While all approaches fall under the governing body for bank and institutional lenders, there is a fair bit of room for them to manage the penalty into their favor if the right circumstances present themselves.
This can leave the borrower not only scratching their head trying to understand how it works, but also leave them facing a considerable prepayment penalty they did not count on or did not properly calculate based on their own understanding of the mortgage terms and conditions.
For a real life example of an IRD calculation that did not excite the borrower holding the mortgage, go to http://www.canadianmortgagetrends.com/canadian_mortgage_trends/2011/03/ird-penalty-comparison-rates.html
The good news is that there are supposed to be federal government guidelines coming out in 2011 that will standardize the explanation of the interest rate differential prepayment penalty, or IRD, which should make it easier to borrowers to not only understand what they’re signing up for at the start of the mortgage, but also provide a more clear outline of how to calculate a potential IRD out at a given point in time if required.
Also keep in mind that his only relates to bank or institutional lenders. Private mortgage financing does not typically have any type of IRD written into the mortgage terms. For most private second mortgage loans, the most common prepayment penalty is 3 months interest, but some can also be fully open after a period of time.
If you are considering a mortgage refinancing action where a new mortgage at a lower rate is going to be paying out an old mortgage at a higher rate, then I would recommend that you give us a call so we can go through your prepayment calculation together and then come up with the best strategy to minimize it.
I'm a Toronto Mortgage Broker that arranges mortgage solutions on residential and commercial real estate property. With over 30 years of mortgage financing experience, I'm able to quickly assess your financing requirements and provide relevant solutions for your immediate consideration. Joe Walsh Google+ YouTube Channel