This is the most difficult topic related to mortgages and it will continue to be confusing until the laws in Canada are changed to require consistency on how lending institutions charge their penalties.
Most lenders charge an early payoff penalty on closed mortgages if the debt is paid prior to the maturity of the term. The lending institution must describe the penalty they could charge on the mortgage document.
The most common penalty is:
The greater of three months interest penalty OR the interest rate differential. In other words, whichever amount is the larger of these two figures will be your penalty. Other kinds of penalties are listed below.
Three Months Interest Penalty
If you are paying off your mortgage before the maturity date, most lending institutions charge three months interest penalty (or an interest differential penalty).
Your present mortgage balance is multiplied by your current interest rate and multiplied by three.
Interest Rate Differential
This usually means the difference between the interest rate on your mortgage contract compared to the rate at which the lending institution can re-lend the money.
If your mortgage has a balance of $125,000 at 9.25%, you have 2 years left to go and the current 2 year mortgage rate is 6.25%.
Then the lending institution will probably charge you – $125,000 X 24 months X 3% (9.25 – 6.25) = $7,266.21
However, just to further confuse the issue, the penalty above has not been present valued. This is when a lender charges a lower penalty because you are paying all of the ‘extra’ interest (in the example 3%) now, not over the remaining term. Some lenders present value, other lenders do not.
Other Penalty Calculations
Methods of calculating penalties are as varied as the lenders’ imaginations! The following outline describes some penalties charged by lenders.
- Greater of three months interest penalty OR the interest rate differential.
- CMHC mortgages registered prior to July 1999 – during the first three years, the penalty is the greater of 3 months interest OR interest rate differential. After three years of payments made on a 4 or 5 year term (or longer) the penalty is three months interest.
- CMHC mortgages registered after July 1999 – CMHC mortgages will now have the same penalty clause as the institution lending you the mortgage funds.
- Two months penalty interest (based on the floating rate in effect at the time of payout) calculated on the outstanding balance during the first three years of the term and no penalty charged at all for the remaining years of the term.
- The mortgage can not be paid out unless there is an arm’s length sale – then the penalty is 3% of the outstanding mortgage balance.
- The mortgage can not be paid out unless there is an arm’s length sale – then the penalty is the greater of three months interest OR 3% of the outstanding balance.
- Same as above, but not more than three months interest in years 4 and 5 of a five year term.
- For non-arm’s length sales – it is the greater of three months interest OR interest rate differential to the bond rate for the remaining term.
- For arm’s length sales – it is the greater of three months interest OR interest rate differential to the current posted mortgage rate for the remaining term.
Here’s More Confusion
- Do not assume the same lender charges penalties the same way for each type of mortgage. Examples 1, 4 & 5 above are all charged by the same lender on different products.
- Do not assume the penalty charges you agreed to with the original mortgage document are the same when you renew with the same lender. Their policies concerning penalty charges are always changing.
- Do not assume the same wording means the same calculation with different lenders. For example the term ‘interest rate differential’ means very different penalty policies with different lenders. The terminology is not used consistently.
- Do not assume your legal representative or real estate agent is familiar with all the different ‘twists and turns’ of penalty charges.
There have recently been class action law suits against at least two Canadian lending institutions over their practices regarding the calculation of penalty charges. The law is still evolving regarding acceptable practices for calculating penalties.