Background Information

To start the topic and give it an independent perspective I would like to highlight a few important points from Peter Spiro’s 2015 Western Journal of legal Studies, Volume 5, Issue 4, Article 4, Canadian Mortgage Law and Prepayment Penalties:

• Inequality of bargaining power: On Page 2 the article states, “There is a lack of consumer protection for borrowers with respect to mortgage interest penalties. This is especially true for individual borrowers, where the inequality of bargaining power leads to potentially unconscionable outcomes.”
• Prepayment charges for shorter-term mortgages are unregulated and remain at the discretion of the lender: On Page 4 the article states “Significantly, over 95 per cent of mortgages in Canada are contracted for a term of five years or less and, therefore, do not fall under section 10.16 [of the federal Interest Act] It is likely that section 10 may contribute to why banks rarely issue mortgages with a term greater than five years because the charges for shorter-term mortgages are unregulated and remain at the discretion of the lender.”
• Section 10 of the Federal Interest Act does not protect most Canadian borrowers for mortgages with term lengths 5 years or less: On Page 4 the article continues, “The evasive actions taken by banks in response to section 10 have resulted in an unregulated system that is problematic for consumers, particularly when the mortgage market is relatively concentrated and oligopolistic. In a concentrated market, companies compete by image and advertising but avoid genuine competition on substantive matters. This is because these companies are aware that it would be a race to the bottom that reduces profits. The banks, whose primary motivation is earning a profit, in effect set the terms of the mortgages. In Canada, the current banking system is more concentrated than in the past.  While a number of smaller players remain in the market, most mortgages are issued by the “Big Five” banks: Royal Bank of Canada (RBC), Toronto-Dominion Bank (TD), Bank of Nova Scotia (Scotiabank), Bank of Montreal (BMO), and Canadian Imperial Bank of Commerce (CIBC).  Therefore, section 10(1) does not protect most Canadian borrowers from an unregulated and highly concentrated market.”
• Interest rates used to calculate penalties are determined by the lender, rather than by a third party, and thus subject to manipulation by the lender: On Page 18 the article states “The CIBC mortgages contained a term that allowed a prepayment charge based on the difference between the interest rate in the mortgage and the current interest rate. The relevant contracts stated that the determination of the applicable comparison rate and the calculation of the prepayment charge would be done “using a method determined by [the bank] from time to time at our discretion.”  Moreover, the prepayment charge was based on the rate currently posted by the lender, rather than some objective third party, and was, therefore, subject to manipulation.  The statement of claim alleges that, because of these terms, the prepayment charge term is void for uncertainty.”
• Damages in breach of contract should compensate for loss of expectation interest: From Page 8 & 9 of the article: “In contract law, penalty clauses incurred upon breach or default are generally unenforceable.39 When a buyer has defaulted, a seller can only keep a buyer’s deposit when it is a reasonable estimate of liquidated damages. If there are no damages resulting from the breach, a penalty amount cannot be kept.”……” “Furthermore, although the parties can “make the predetermination . . . it must yield to judicial appraisal of its reasonableness in the circumstances.” Thus, where a penalty is not a reasonable estimate of damages, it is not reasonable and should not be enforced.

“…..This principle is not easily applicable to situations where the mortgagor wants to pay off the mortgage early.  Essentially, the mortgagor is asking the mortgagee to grant something that the mortgagor is not contractually entitled to—to accept payment and discharge the mortgage early.  There is no breach of contract per se, but rather a payment in lieu of notice.  The mortgagor is not in breach of contract until it fails to make monthly payments.  The major Canadian banks use similar terms for calculating the prepayment charge.  In all cases, the minimum prepayment charge is three months’ interest, regardless of the duration remaining on the term of the mortgage.  If interest rates fall compared to the existing interest rate in the mortgage, the standard mortgage contract calls for the prepayment charge to be even larger.  If a prepayment charge was included in the contract, the bank will then re-lend the money at a lower interest rate and will require the mortgagor to fully compensate it for the “interest rate differential” over the remaining term of the mortgage.  This prepayment scheme is justified under the general principle of contract law: damages in breach of contract should compensate for loss of expectation interest.”

“Conversely, the one-sided nature of the agreement detracts from the reasonableness of this justification.  For example, where the current market rate is higher than the mortgage rate, it is beneficial to the bank to have its money repaid early.  The bank will likely re-lend the funds to a new customer at a higher rate, but the bank is not required to discount the principal amount to be repaid by the borrower.  Economically, the repayment may be a windfall to the bank, even without a prepayment charge.  Where the rates are significantly higher, there may be less demand for mortgage loans.  However, the bank will likely be able to lend its money elsewhere at a higher rate.  Such a one-sided situation is unlikely to occur where both parties have equal bargaining power.”

Mortgage Term Types:

Let’s determine which mortgages are subject to mortgage penalties.  Most lenders classify mortgages into “open” or “closed” terms, but this is incomplete and the definitions of “open” and “closed” that you were taught are probably only partially true.  Here are the various mortgage term types:

• Open Mortgages: The borrower can usually exit the mortgage without incurring mortgage penalties. These are usually higher interest rate, temporary mortgages and not recommended as regular mortgages.  Home Equity Lines of Credit are usually also open.  Open mortgages can have either fixed or variable mortgage interest rates.
• Closed Mortgages: Despite what most lenders state, closed mortgages can be paid out midterm ONLY upon a bona fide sale. These mortgages are subject to mortgage penalties.  Closed mortgages are not limited to fixed or variable rates.  Lenders usually offer these mortgages at slightly reduced rates, but unless a borrower has a very specific and suitable need, these mortgages should be avoided because of their restrictive terms & conditions.
• Partially Open Mortgages: You probably previously referred to these mortgages as closed, but most of the mortgages that we consider to be “closed” are actually partially open, because the borrower can payout the mortgage mid-term subject to a mortgage penalty. Partially open mortgages can have either fixed or variable mortgage interest rates.  These mortgages are typically the best long-term mortgages.

The colloquialisms we use in the mortgage industry have in many cases unintentionally become the only definitions we all use, so if you asked your bank for a “partially open” mortgage they may not understand you or try to correct you, but if you can payout your mortgage midterm, subject to a penalty, your mortgage is probably partially open.

When are Mortgage Penalties Applicable:

Prepayment penalties can apply to closed and partially open mortgages if you pay an amount greater than your allowable prepayment privileges or you payout your mortgage prior to your term maturity date which the following events can cause:

• Sell your home and choose to pay out the mortgage prior to its maturity date.
• Renew your mortgage prior to its maturity date.
• Refinance your mortgage.
• Transfer your mortgage to another lender.

Who Calculates My Mortgage Penalties?

While any appropriately skilled person with access to the required data can estimate your mortgage penalties, your lender is the only entity whose calculations are accepted for mortgage payout purposes.

Mortgage Penalties have a Limited Life:

A lender’s mortgage penalty quote is usually valid for the day of the quote only.  While clients may understand that their penalties may change incrementally as they reduce their mortgage balances, they are often shocked when their final mortgage penalties differ significantly from their original quote, without their lender warning them and for no apparent good reasons.  These events can suddenly and significantly impact your mortgage penalties:

• Mortgage Balance Changes: Mortgage penalty calculations are based on your remaining mortgage balance, so a major change in your mortgage balance can cause a major change in penalties.
• Time Remaining to Your Term Maturity Date: The time remaining in your existing mortgage term reduces as time you pay off your mortgage and move closer to the mortgage term maturity date.
• Lender Posted Rate Changes: If your lender changes its posted rates used for penalty calculations, the change may impact the difference between your actual interest rate and the lender’s new posted rate, which can change your mortgage penalty.
• Available Contract [actual] Interest Rate Changes: This will change the difference between your mortgage’s posted rate and the actual interest rate, which can change your mortgage penalty.
• Mortgage Penalty Calculation Methods: When determining a suitable comparison rate, some lenders round up and others round down your remaining months to the next longest term. This can cause an unexpected change in your mortgage penalties.  The comparison rate is the lender’s rate for the term most closely matching your remaining term.

Mortgage Penalty Types:

As we saw from Peter Spiro’s article, mortgage penalties for 5-year term lengths or less are essentially unregulated, so it is impossible to cover all penalty types, calculations, etc.  I will only cover the most common mortgage penalty types:

• Interest Rate Differential [IRD] Penalties: Loosely stated, the IRD penalty is the amount a lender will lose over the remaining mortgage term if the mortgage is paid out before the maturity date and the lender has to re-lend the funds to a new borrower at a lower interest rate. IRD penalties are mostly applicable to fixed rate mortgages.  Beware!  While all lenders may use this same IRD terminology their IRD penalty formulas, calculation methods, penalty calculation interest rates and hence their IRD penalties can vary significantly and prohibitively.
• Number of Months’ Interest Penalties: A lender may impose a prepayment charge on a borrower based on several months’ interest, usually 3 months. These penalties are mostly applicable to variable and adjustable rate mortgages.

Note:  While lenders may state their penalties to be “3 Month’s Interest” which is the same terminaology used by other lenders, lenders’ calculation interest rates and hence their 3 months’ interest can differ significantly from other lenders.

Note: Some lenders may calculate 3 months interest rates for fixed rate mortgages differently than they do for variable/adjustable rate mortgages.

• Percentage of the Mortgage Balance Penalties: The lender’s prepayment penalty is a percentage of the remaining mortgage balance. E.g. 3% of the mortgage balance. This penalty type can apply to fixed or variable mortgage types and are not as common as other mortgage penalty types.

Notes about Penalty Types:

• Mortgage Terms Greater Than 5 Years: For mortgages with terms greater than 5 years, after the 5^th year the prepayment charge is calculated using a 3 months’ interest charge.
• Less Than 3 Months Remaining of the Term: If, at the time of prepayment, there are less than three months remaining before a mortgage matures, a per-diem prepayment charge applies for the duration of the remaining term.

In this section we will discuss more penalty information, the most common penalty variables, methods & calculations and some estimated examples.

Fixed Rate Mortgage Penalties:

Although other methods may exist, closed or partially open, fixed rate mortgage penalties are usually determined by the following methods:

• IRD vs 3-Months’ Interest: The larger of the Interest Rate Differential [IRD] penalty or 3-months’ interest using your lender’s calculation methods/formulas, etc. This is the most common fixed rate penalty determination method.

Note: IRD penalties are usually applicable in a decreasing rate environment and/or if your existing interest rate is higher than your lender’s current rates.

• Percentage of the Mortgage Balance Penalties: The lender’s payout penalty is based on a percentage of the loan amount you wish to payout. E.g. 3% of the remaining loan amount.

Variable/Adjustable Rate Mortgage Penalties:

Although other methods may exist, closed or partially open, variable/adjustable rate mortgage penalties are usually determined by the following methods:

• 3-Month’s Interest: This is the most common method.
• Percentage of the Mortgage Balance Penalties: The lender’s payout penalty is based on a percentage of the loan amount you wish to payout.

Penalty Calculation Variables:

These are the most common variables used in mortgage penalty calculations

• Payout Balance: [$] The remaining loan balance or loan amount you want to payout.

Where: Your most recent mortgage statement

• Term Posted Interest Rate [%]: Your lender’s posted rate at the time of your existing mortgage closing date.

Where: Your original mortgage documents.

• Term Contract Interest Rate [%]: This is the actual interest rate used to calculate your existing mortgage payment.

Where: Your original mortgage documents or most recent mortgage statement

• Prime Interest Rate [%]: This is your lender’s Prime mortgage rate.

Where: Your lender’s website

• Prepayment Mortgage Term [Years]: This is your lender’s effective remaining mortgage term at the time you payout your mortgage. [You need your lender’s prepayment term table to determine your Prepayment Mortgage Term]

Where: This is often difficult to find.  You should be able to find the prepayment term table in your original mortgage documents or your annual mortgage statement.

• Prepayment Posted Interest Rate [%]: This is your lender’s posted rate for its equivalent Prepayment Mortgage Term.

Where: Once you have determined your prepayment mortgage term, you should be able to find the equivalent term’s posted rate on your lender’s website.

• Months Remaining: These are the months remaining in your mortgage term from your payout date until your term maturity date.

Where: This is often not provided to you by the lender, but it is easy to calculate.  Months Remaining = Original Term [Months] – Lapsed Term E.g. Paying out your mortgage after 3 years of a 5-year term | Convert the years to months: 3 years x 12 = 36 Months & 5 years x 12 = 60 Months.  Months Remaining = 60 – 36 = 24 Months

 

Penalty Examples:

As I mentioned before lenders use very different calculations, interest rates and methods to calculate their payout penalties.  Although not comprehensive, the table below highlights:

• Mortgage penalties for mortgage terms less than 5 years are not standardized.
• Penalties can differ significantly across various or even the same lenders’ mortgages.
• Harsh penalties, hidden in the mortgage terms & conditions, can easily erase any perceived savings from fractionally lower contract interest rates.
• As a rule, the deeper the lender’s discount, the bigger the payout penalty.

All the information you need to calculate and understand a lender’s penalties are usually not readily available before you get the mortgage.

I hope this article helps you to plan your mortgage to protect you against life’s circumstances.  Many clients don’t plan for eventualities that may cause them to payout their mortgages even though up to 30% of mortgages are paid out before their maturity dates.  Mortgage penalties can be very expensive, but these penalties can at the very least be reduced with the right mortgage.