Paying Out a Mortgage Before Maturity

Falling interest rates have more homeowners thinking about whether it would make sense to break their existing mortgage and refinance. One major lender reports that in recent weeks 90% of their new applications have been for refinances.

There are some pitfalls to keep in mind as you advise your clients on the strategy that’s right for them.

1. Lender Rules

The typical penalty for breaking a fixed-rate closed mortgage has been the greater of a three-month interest penalty or interest rate differential (IRD) penalty. With rates having fallen so drastically, these days the IRD is frequently the applicable penalty, and it is often larger than expected for many clients.

Note that not all lenders calculate the IRD in the same way. Lenders typically base the IRD on the difference between the contract rate in the mortgage document versus the discounted rate on the term remaining. However, there are variations to this. Some lenders will base the IRD on the posted rate (National Bank, for example). Some lenders have closed terms that cannot be paid out unless there is a sale of the home (certain MCAP products). Some lenders will charge the IRD based on the Government of Canada bond rate for a bond of a similar term – this may result in a sizeable penalty for the client. Other lenders may base the IRD on the discount the client was originally given.

Some other points:

• Lenders may change their current policies on the method of IRD calculation, no matter when the mortgage was taken out (depending on how the mortgage document is written).

• For CMHC insured mortgages, some lenders will not permit a refinance if the client is less than one year into their term with their current lender.

• If the client has a term longer than five years and they are now beyond the fifth year, the three month penalty applies, not the IRD.

• Variable-rate mortgages do not have IRD penalties.

• Some lenders are looking carefully at refinance applicants’ credit card delinquencies as an indicator of likelihood of default. Also, a history of chronic refinancing (say, every two or three years) may raise a red flag with some lenders.

• The penalty to refinance may be added to the new mortgage balance.

• Note that in most cases you cannot add the penalty on if the new mortgage is a switch. However, a couple of lenders will allow you to add a certain amount of the penalty in on a switch. Firstline will allow up to $10,000 to be added to the mortgage, provided that it is conventional and the new amount doesn’t amount to more than the original registration. ING will allow you to add $5000. The advantage is that this can save the client the legal fees of a refinance.

• In some cases a borrower may be able to apply their annual pre-payment privilege before paying off their mortgage, thereby reducing the principal amount and in turn reducing the IRD penalty.