Now that the Bank of Canada has paused their rate hikes and interest rates are seemingly at their peak, we have noticed a lot of our clients are unsure about whether they should lock in a fixed rate for the next five years. With many of our clients, we have recommended taking a shorter two or three-year term fixed-rate mortgage. This will help them to take advantage of today's lower property prices and also avoid the penalty of breaking their mortgage early should the rates drop before their five-year term was over.
Research shows that over half of Canadian households break or renegotiate their mortgage before their term is up. When you break a mortgage before its maturity, you will face a penalty charge. This penalty will be whichever amount is greater out of three months of interest or the interest rate differential.
How do banks calculate your penalty?
Let’s assume that you have a five-year fixed-rate mortgage with an interest rate of 5.34%. You have two years left on your term and a $400,000 current mortgage principle.
To calculate three months of interest on your mortgage the bank would multiply your original mortgage principle by your original mortgage rate. ($400,000 x 5.34% = $21,360) This amount is then divided by four ($21,360 / 4 = $5,340) So, in this scenario your three-month interest penalty amount would be $5,340.
To calculate your interest rate differential (IRD), the calculation is a little different. To begin with, the lender will find your current lender's mortgage rate for a term equal to your remaining term. So if you have two years left of your mortgage term, the lender would look for your current lender’s two-year fixed rate, let’s assume this is 4.52%. The current rate is then subtracted from your original rate (5.34% - 4.52% = 0.82%). Your principal mortgage amount is then multiplied by the interest rate difference ($400,000 x 0.82% = $3,280) That amount is then divided by twelve ($3,280 / 12 = $273.33) Finally this figure is multiplied by the number of months remaining in the term of your mortgage, in this case, that would be 24 ($273.33 x 24 = $6,559.92). In this scenario, your IRD penalty would be $6,559.92.
In this scenario, you would pay the $6,559.92 IRD penalty as that is the higher of the two.
Are there additional costs to breaking my mortgage?
When you break your mortgage before the term is complete, you will need to take out and qualify for, a brand-new mortgage. Refinancing your mortgage will come with additional fees which can include: appraisal fees, legal and registration fees, title insurance, reinvestment fees and more.
It is also important to consider that to refinance your mortgage you will need to requalify as if this is a brand-new mortgage. This means submitting a new application and being subject to credit and employment checks.
If you need to break your mortgage, check out our mortgage calculator to see how much you can afford and as always if you have any questions about your options, our brokers are happy to help.