Mortgage Penalty, I.R.D., Interest Rate Differential, Paying off your mortgage before maturity, Mortgage Refinance

What is an Interest Rate Differential Mortgage Penalty?

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Debt Consolidation Milton

When getting into a mortgage contract there are options and features that most of us do not think of, with rate being the only factor in our minds. Much of the reason why we do not is simply because multi-millions of dollars are spent each year brain washing the general population into thinking that the mortgage rate is all there is to worry about.

Mortgage rates are carrots being dangled from sticks above, where the stick is the rest of the verbiage in the contract, including the mortgage penalty should you have to break this contract before maturity.

However, life happens, and when the unforeseeable hits you, and you need to do the unthinkable, and payoff the mortgage, whether it is because of selling, or refinancing, etc, then the IRD (Interest Rate Differential) calculation variance from lender to lender can make a huge difference.

The IRD is a compensation charge that may apply if you were to payoff a mortgage earlier than the date the mortgage comes due (the maturity date).

Generally it is based on

  • The amount you are pre-paying: and,
  • An interest rate that equals the difference between your original mortgage rate (the one of the mortgage contract you signed) and the interest rate that the lender can charge today if they were to lend that amount on another mortgage for the remainder of the mortgage term.

However, in real life, it is not so straight forward. There are 3 methods that we know of that I.R.D. penalties are generally calculated.

  • The standard I.R.D. calculation
  • The discounted rate I.R.D. calculation
  • The posted rate I.R.D. calculation

Let us have a closer look at some examples. In all the examples we will use the following information

Remaining months in the mortgage term: 26 months fixed closed mortgage

Interest Rate: 3.6%

Mortgage amount being paid off: $200,000

 

  1. The Standard IRD Calculation

This matches the rate you have on the mortgage to the rate that the lender is presently offering on a term that matches or is close to the remaining term of your mortgage.

So, if you are breaking the mortgage 26 months early, then they will check and use the rate they are offering on a 2 or 3 year term for example (if they offer them).

Let us assume that the rate is 3.0% that they can offer on a 2 year term to a client who walks in and gets a mortgage.

So the calculation is as follows

(Your current mortgage rate) 3.6% - (Lender’s present matching mortgage rate) 3.0%/12(number of months in the year) X (Mortgage you are paying off)$200,000 x (Months remaining in your term) 26

= $2600 in mortgage penalty

 

  1. The discounted IRD calculation

If you recall lenders advertising their posted rates when you walk into a branch, and wonder what they are for when nobody really gets a mortgage at those rates, enter the world of IRD. With posted rates a lender can charge a higher mortgage payout penalty than a standard calculation.

In this example we assume

The Posted rate at the time when you got the mortgage : 5.1% (This is posted rate they had on a 5 year term at the time)

So when you got the mortgage at 3.6%, you received a discount of 5.2% (POSTED RATE) – 3.6% (Your mortgage rate) = 1.5% (The discount you received)

The rate on a matching 2 year term now: 3.3% (The POSTED RATE on a 2 year term.

Point to note is that lenders have different POSTED RATES for different terms, and shorter term mortgage POSTED RATES are generally much lower than the 5 year POSTED RATES.

So , where a 5 year POSTED RATE may be 5.1%, a 2-3 year POSTED RATE may be 3.5%.

Here the calculation is as follows:

{(Your present mortgage rate) 3.6% - (Lender’s POSTED RATE that closely matches your term) 3.3% - (The original discount you received at the time) 1.5%}/12 (number of months in the year) x (Mortgage amount pre-paid) $200,000 x (Months remaining) 26 = $7800.

Just by adding the discounted rate into the calculation the lender can now charge you $7800 for the same mortgage.

 

  1. Posted rate IRD calculation

This method gives the lender the most bang for their calculation wizardry.

Assuming the same as above

The Posted rate at the time when you got the mortgage : 5.1% (This is posted rate they had on a 5 year term at the time).

This is where a lender can come in and argue their posted rate being used is different, then you may be out of pocket even more. So, lets say the lender uses 3.1% instead of 3.3%.

Then the calculation will be

(Posted rate at the time you got the mortgage) 5.1%- (Posted rate the lender is using now)3.1%/12 x$200000 x 26 = $8667

 

So as you can see from the examples above, if one lender was offering 3.5% but calculated penalty based on POSTED RATE while another lender was offering a 3.7% but calculating penalty based on STANDARD I.R.D., then the lender with a higher rate may still be a better option if you needed to pay it off sooner.

That is why knowing how a lender may calculate the penalty if you needed to pay it off sooner than the maturity date can potentially save you thousands and can help you choose a better mortgage.

 

 

 



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