Interest rate differential (IRD) penalties are one of the more complex parts of the mortgage world for borrowers. These penalties can affect fixed-rate borrowers who break their mortgage contract, but how exactly do they work? It’s important to understand how IRD penalties might impact you, and how your lender may calculate them. Here are the basics you should know.
What is an interest rate differential penalty?
Mortgage prepayment penalties are often due to prepayment violations or contract breaches prior to the end of the mortgage term. A fixed-rate mortgage penalty will be calculated based on the greater of an IRD or three months’ interest, and, in some cases, IRD penalties can be quite large. The IRD is a more complex calculation than a three months’ interest penalty. The IRD is based on the amount that you are prepaying, and the difference between your original mortgage interest rate and the interest rate that the lender can charge today, if they were to re-lend the funds for the balance of the term of the mortgage. If you secured a mortgage with a vastly higher interest rate than that product has now, breaking your terms means you will have to pay a penalty based on today’s rates. Each lender’s calculations are different, so keep in mind how your particular lender will work out your penalty.
Why do they exist?
So, why can’t fixed-rate mortgages just have the three months’ interest rule like variable-rate mortgages? Variable-rate products are directly related to the Bank of Canada’s prime rate decisions. Whenever the prime rate moves up or down, lenders’ variable rates move accordingly. However, fixed rates do NOT move along with the prime rate, but rather with the bond market. This means sometimes, fixed rates will be higher and more expensive than available variable rates. If a borrower refinances to a variable rate, lenders are at a loss unless they can regain that profit. Borrowers then may have to pay the IRD penalty in order to break their terms and effectively pay the lender what they owe.
How do they affect you in today’s market?
Today, we are seeing variable rates climbing higher than fixed rates, as the Bank of Canada continues to raise the prime rate. Meanwhile, fixed rates are dropping as the bond market prepares for a possible recession. Borrowers may not be looking to jump to a variable rate as a result right now, but if they do, they may be switching to a higher interest rate in the short term. It’s worth noting that variable rates will likely drop as well in the future if we encounter a downturn, but right now they are often higher than fixed rates.
People have several motivations for wanting to refinance their mortgage. Accessing home equity, securing a better rate, shortening the amortization period, and gaining prepayment privileges are just some of the reasons borrowers may need to make these changes. Before you do, however, it’s important to think about how an IRD penalty might affect you. You need to speak to your lender about their specific penalties, and whether the changes you’re looking to make are worth it. You should also get in touch with a mortgage broker to help you evaluate your options! We can discuss your situation and your goals to find you a product that benefits you.
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