Penalties for breaking mortgage – how much do we know about it and how do they get so high?
When the time comes to purchase a property or to renew a mortgage, many people take their business to a major bank. Why? Simple reasons; it’s convenient (all of your banking is done through one place), reliable (it is a major bank), “they already know me” (true, they did ask for your photo ID around the time you first met to confirm your identity).
But how much do we know about the conditions of the mortgage contract we process through a major bank and why are we so surprised that, when we have to break the contract, the penalties are astronomical? We are often angered by the numbers, and then, we settle and tell ourselves: “Yes, that is how banks work and nothing can be done.”
So why not do your homework ahead of time, analyze and pick conditions that will not result in these outrageous penalties?
Let’s compare conditions on a mortgage at a few financial institutions. For simplicity, we will refer to them as big and small bank.
By the way, there is absolutely no risk from going with a smaller bank. The most important thing is to understand the conditions in the contract. That is why we have mortgage specialists. They will surely assist you with understanding these details. Until the term of the contract expires, it cannot be modified, even if the institution goes bankrupt. There will always be another bank that will assume the responsibilities of the smaller bank and will continue to service existing contracts. The new bank will have no legal right to modify contracts until the end of the term.
Of course, mortgage specialist would know that the small banks offer a variety of products that also have defined larger penalties. These products often have unique names: Low Rate Mortgage, No-Frills Mortgage, etc.
Often clients will demand the best rate and it is the mortgage broker’s responsibility to explain what kind of consequences to expect when obtaining such a low rate.
I would like to compare standard mortgage conditions of a small bank with the same mortgage conditions at a big bank.
I will not focus on the conditions that are identical or almost identical between different banks.
For example: PREPAYMENT PRIVILEGES
Big banks allow increase in monthly payments by 15%, making a double payment, prepaying additional 15% of the original mortgage amount. (Some will allow only 10% prepayment and only at each anniversary; some 15% through the year.)
Small banks allow increasing monthly payments by 20%, prepaying up to additional 20% of the original mortgage amount and allow that through the year. Some will say that a big bank will allow a double payment, while a small bank only allows a 20% increase on regular payment. Few people realize that the limit of increasing payments with a small bank actually works out to be much higher. For example, you have $400,000 mortgage amount with, let’s say, a monthly payment of $2,000. You can increase regular monthly payments by $400 per month (20% of $2,000) and still have the second prepayment option available to you. It means the 20% prepayment, $80,000, can be broken down and added to your regular payment up to as much as $6,667 extra per month, you can basically set $8,667 as your regular monthly payment.
Majority of people do not need this, they simply cannot afford it. What I am trying to present here is that small banks really compete for your business and offer truly better flexible conditions. Additionally, majority of smaller banks provide online banking allowing you to monitor and adjust your mortgage at any time.
Ability to switch your mortgage from variable to fixed during the contract term.
In reality, all banks offer the option to switch from variable to fixed rate. The question is what are the conditions offered by the bank at that time?
As an example I want to use my conversation with a TD bank from December of 2009.
In December 2009 I purchased a property and chose the variable rate, understanding that the penalties on a variable rate mortgage are smaller if I choose to break the contract. I knew that I would likely break it in the next couple of years. At the time, the variable rate was exactly 3% (Prime with no reductions), fixed rate at the time was 4%. 3 weeks later I contacted the bank, specifically to find out what would happen if I decided I wanted to switch from a variable to a fixed rate. I called because one person told me that his TD bank will always offer him the best deal. I decide to make the call right in the front of that person and ask what will happen if I decide to switch from variable to fixed rate.
The bank representative told that switching from variable to fixed rate is available at any time but after a 10-minute conversation I was told that the fixed rate I would be able to get is 5.79%. That was the posted rate at the time. I questioned such high rate, just 3 weeks ago I was offered 4%, I was told that “today” that is the only rate that can be offered to me.
Let’s understand what the “today” means:
3 weeks prior I was a new customer, I had the freedom of going to any other bank. Today I am the person that cannot go anywhere without having to pay penalties. The bank understands this and offers me, lightly put, not their best rate.
Unfortunately all big banks at the time of switching variable to fixed rate, offer either Posted Rate or Posted minus 1%. In either case, it will not be a good rate that is offered in the market at the time.
Smaller banks do not have a posted rate and offer a better rate when switching from variable to fixed rate. It wouldn’t be the best rate (the best rates are only possible with broker buying down the rate with own commission), but it would be a good rate, currently available on the market.
Penalties for breaking the mortgage contract prior to completion of current term.
Everyone knows that if the contract is broken under a Variable Rate Mortgage the penalties are the 3 months interest. This is how it works unless other conditions are specified in the contract. As we already mentioned the broker should be informing you of any such conditions in advance.
But if you are breaking a Fixed Rate Mortgage the penalties can be quite substantial. All banks have the same explanation of the penalty: it will be the higher amount of 3 Months Interest or Interest Rate Differential (IRD).
3 Months Interest is easy to understand and calculate, the Interest Rate Differential is harder to describe and calculate.
Smaller banks, in the absence of Posted Rate, are guided by “LOGICS”. The logics are as follows – If the bank receives the payout from you and passes it as a loan to another client, they lose money and they want to compensate their loss. If these losses are more than 3 months interest, bank will charge you a higher penalty.
Big banks will calculate their, so called, losses in a much different way. The most interesting part is that bank employees cannot explain how it is calculated. They just say that there is a formula and it calculates…
I would like to estimate and calculate the following scenario:
Just recently a family obtained a mortgage from Scotia Bank in the amount of $400,000 with a 2.69% interest.
At the same time another family obtained same mortgage at the same rate but with a smaller bank.
First I want to note the initial information such as Posted Rate for all terms – 1 – 5 years – as well as the real rates that I am able to obtain with both of these institutions as a mortgage broker.
Posted rate is the rate officially posted at a Scotia Bank website.
The fixed rates posted on the bank’s website are as follows:
1 year (Posted Rate) – 3.29%, a good client or a broker rate of 2.79% can be obtained.
2 year (Posted Rate) – 3.09%, lowest available 2.29%.
3 year (Posted Rate) – 3.39%, we get 2.39%.
4 year (Posted Rate) – 3.89%, we get 2.59%.
5 year (Posted Rate) – 4.49%, we can get 2.69%.
Have any of you ever thought as to why the bank posts all these rates on their website? Have you? Great! Have you come up with the answer? Most likely not because it is almost impossible, you could lose all your clients like that. But the banks do not worry, they have many clients and surely someone will ask what rate can you offer me on a mortgage?
This is where the bank starts telling you how valuable you are, and that you will get the best discount of 1.8%. The client asks what does that translate into for me? The bank says – 2.69% – great rate, sign me up. Sometimes a client will enquire about a variable rate. The response will usually be why, get the fixed rate and sleep well at night.
If those clients knew the penalties they may have to pay, they probably would not be sleeping so well. Not many people get into many details on this when they sign the contract though.
At the same time, smaller banks offer the following rates:
1 year – 2.69%; 2 year – 2.29%; 3 year – 2.34%; 4 year – 2.54%, 5 year – 2.79%
For brokers with larger business volumes, the banks offer slightly better rates. I am using this particular bank to try to closely match the information we have for the big bank.
1 year – 2.59%; 2 year – 2.19%; 3 year – 2.24%; 4 year – 2.44%; 5 year – 2.69%
You may have noticed that a better rate can be obtained; I am using the numbers considering broker receives full commission. If the broker is eager for business he can obtain a lower rate and get paid less. This all depends on each specific situation. I am just analyzing a standard situation.
So the rates are approximately same. Let’s pretend that, in a few years, we have to break a contract on a $400,000 mortgage (let’s not talk about such things not happening and the existence of portability – these situations happen very often). For simplicity we will assume that all rates remained the same.
With a smaller bank:
3 months interest = $400,000 x 2.69% = $10,760 : 12 month x 3 months = $2,690
Interest Rate Differential (IRD) = difference for the remaining 3 years between your rate (2.69% ) and the rate offered by the bank on a 3 year term (in this example it will be 2.44%).
$400,000 x 0.25% (2.69% – 2.44%) = $1,000 x 3 years = $3,000
Of course, the bank will take the higher, $3,000.
Now, let’s look at how the larger bank will calculate this.
3 months interest = $400,000 x 2.69% = $10,760 : 12 month x 3 months = $2,690
Interest Rate Differential (IRD) = difference for the remaining 3 years between your rate (2.69% ) and the rate that is calculated as follows – Posted Rate, offered by the bank on the remaining period (in this example 3 years, so it will be 3.39%) minus the discount that you received at the time you signed the contract, which was 1.8%.
$400,000 x 1.1% (2.69% – 1.59% (3.39% – 1.8% = 1.59%)) = $4,400 x 3 years = $13,200
Of course, the bank will take the higher, $13,200.
You know we can’t avoid using big banks, at times, they offer products that are not available through other financial institutions. But, if you are to get the same rate from a mortgage broker or a large bank, please, consider this before deciding on a major bank.
Additionally, brokers will almost always offer a better rate than a large bank. As far as our office goes, we always offer rates that often even bank employees cannot get at their bank with their employee discounts.
We hope to hear from you soon.