Thinking of getting out of your current mortgage before the end of the loan term? Know how to calculate your mortgage penalty.
It may be tempting to change the terms of your mortgage with so many mortgage options.
Many of us have been there. You are having coffee with a couple of friends and the topic of mortgage rates may come up. Especially now in the era of historically low mortgage rates. It is mentioned that one of your friends has managed to lock in a great interest rate while another is switching to a variable rate mortgage and waiting for potentially even lower interest rates.
You may begin to question whether the terms that you hammered out with your lender are the best terms, given the different options that are currently out there. You may have already been thinking long and hard about just how well your mortgage is working for you and just how comfortable you are with your current mortgage terms.
You can break your current mortgage but be aware of the prepayment penalty you will be facing.
Yes, you may only be two and a half years into your five years fixed mortgage rate mortgage. This does not mean that you are necessarily locked into your current mortgage. There may be a way out. In most cases, a mortgage loan can be terminated before the negotiated end of the term. Should you break the mortgage contract before it is up for renewal?
The answer lies in what you may be facing in terms of a prepayment penalty. The only way you can truly answer whether breaking the mortgage contract before the end of the term lies in exactly how much you will owe and whether you can afford this penalty moving forward, keeping in mind any other costs associated with negotiating a new mortgage loan.
There are formulas in place that will let you determine exactly what the prepayment penalty cost will be.
The mortgage industry has put in place precise formulas that will determine what penalty will be owing when a client is breaking a mortgage early. This contingency plan helps the lenders absorb any costs associated with breaking negotiated mortgage loans earlier than that agreed-upon term end of the loan.
There are two basic formulas that are used to determine the prepayment penalty on a broken mortgage loan:
- 3 Months interest formula
- Interest rate Differential formula (IRD)
Most variable mortgages are 3 months interest and most fixed are the greater of IRD or 3 months interest.
Let’s take a look at how each one works, as well as what are some of the types of mortgages each equation is used in conjunction with. When calculating the penalty associated with breaking a mortgage it is important to keep in mind that the penalty is not fixed in stone. It will vary from mortgage lender to mortgage lender. It would be advisable to contact your mortgage provider at the outset and ask how the prepayment penalty is calculated specifically with them. Most lenders have a penalty estimator on their websites.
By the same token, the type of mortgage will also determine in large part the equation that your lender will be used to calculate your penalty. Having established the potentially wide variance in determining penalties, it can be stated that it boils down to the two basic formulas listed above.
Just how do these formulas work?
Let’s take the example of when a 3-month interest formula would be used to calculate the prepayment penalty. A typical example of the type of mortgage that would suit this equation is a closed variable rate mortgage. In the most basic terms, the equation would look like this:
If you have for sake of argument a 400,000 dollar mortgage with a 2.1 percent interest rate a lender would calculate your prepayment penalty by taking the amount of your loan ( 400,000) dollars and multiple this by the interest rate (2.1) and then divide by 4 ( this is a quarter of a year or 3 months penalty)
400,000 x 2.1/ 4=2,100
In this scenario, your prepayment penalty would be 2,100 dollars.
When would an IRD calculation be made then? A typical loan that a lender would utilize the IRD formula to calculate your penalty would be a Closed fixed-rate mortgage. As the equation states, we are looking for the difference between the interest rate that is assigned to your mortgage loan and the current interest rate that is available. Your penalty is based on the interest that the lender may be losing by terminating your mortgage loan early.
Don’t forget that you will need to use two interest rates to calculate the interest rate differential. The interest rate assigned to your current mortgage and the interest rate currently available on a loan with the number of years left on your loan. In other words, if you are only 2 years through your current 5-year term mortgage loan you will need to factor in the interest rate you have been charged and a current interest rate on a 3-year mortgage term being offered now ( three, being the number of years left on your loan).
There is a huge difference between the big 5 banks and monoline lenders. Most big banks will use a discounted rate when applying the penalty calculations. This will normally increase the penalty 20 to 50% over nonbank lenders.
Some contacts even include specific additional penalties such as IRD or 3 months PLUS 3% of the balance.
It is VERY important you thoroughly understand the mortgage you are getting. Sometimes a small upfront discount is not worth it.
You are armed with the knowledge and ultimately the decision is up to you.
With a mortgage, you are never locked in if you really feel that you want to change the mortgage term. Maybe it is important for you to go with a different lender or take advantage of current interest rates that may be lower. Having said that, it is imperative that you are able to have the tools and information on hand to determine how such a decision may affect you financially.
You are best to look at what type of mortgage you have, contact your lender to ask all the relevant questions, and know exactly what penalty you will be facing. We have provided some typically used equations that lenders will be used to determine just that. The ball is in your court. Stay the course on your current mortgage or take the plunge and break your current mortgage. If you choose the latter, this would allow you to take advantage of some of the current mortgage interest rates or tailor the terms of the new mortgage to fit your current economic circumstance and lifestyle.
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