Finance: Fixed Rate Mortgage Penalties

Unlike riskier floating rate mortgages, where the interest you pay to borrow money can change, fixed rate loans comes with a guarantee of what that loan will cost you for the term.What some Canadian homeowners with a closed mortgage may be unaware of is the high cost to break it before the term is up. Many times home buyers do there due diligence by shopping around for the best rate to save money, but fail to look at what penalties would have to paid if they tried to get out of that agreement. If you’re condo hunting this busy season, and concerned about the costs of breaking your current mortgage, here’s what you need to know.How closed mortgages workAlso called fixed mortgages, closed mortgages come with a fixed cost of borrowing for a fixed term. The mortgage agreement is a contract with the bank that the borrower agrees to keep to. If the borrower decides to pay that mortgage off before the term is up or break the mortgage for a better rate somewhere else, they will have to pay what is called an interest rate differential or IRD. This is the money the bank will no longer receive from you the borrower because you decided to end the agreement early.How the penalty determined According to the Financial consumer Agency of Canada the prepayment charge for a closed, fixed-rate mortgage is usually the greater of three months’ interest on the outstanding balance of your mortgage, or IRD. That is an amount based on the difference between two interest rates. The first is the interest rate for your existing mortgage term. The second is today’s interest rate for a term that is similar in length to the time remaining on your existing term. For example, if you have three years left on a five-year term, your lender would use the interest rate it is currently offering for a three-year term to determine the second rate for comparison in the calculation.Calculating IRD Mortgage holders can use a number of online calculators to figure out what their penalty or IRD would be if they wanted break their mortgage agreement before the maturity date. If interest rates have gone down since you signed your agreement the IRD can be very high. This is because it is based on the amount you are paying and difference in the interest you fixed with the bank and the interest rate that the lender can charge today when re-lending the funds for the remaining term of the mortgage. If rates have gone up the penalty may be more affordable.Other charges to be aware of Mortgage holders often receive a fixed rate that might be better than the posted rate. This is often referred to as a posted rate. If you choose to break that mortgage early, the bank may calculate your IRD at that higher rate before the discount. There is little mortgages holders can do about this as there is no uniform system among lenders about this or regulation by the Bank Act. Best advice when getting a mortgage ask how the penalty is calculated, if the bank bases it on the non-discount rate, than this mortgage may not be the right one for you.RUBINA AHMED-HAQ is the Finance Editor for HPG. You can read her musings in Condo Life and Active Life. She's also the Family Finance Advisor for PC Financial. She regularly contributes on TV and radio including CBC Radio, CBC News Network and Global News Toronto. Follow her @alwaysavemoney