How Mortgage Payment Penalties Work
What we find most surprising when dealing with Sellers is that they rarely know how a mortgage prepayment penalty works. Either it was never explained to them. By either the mortgage broker, their bank, or their lawyer. Or, they never took the time to understand this important factor of mortgage payout penalties, when they first mortgaged their property.
In today’s interest rate environment, our clients are seeing some very severe penalties. This is due to a little-known clause on prepayments. The mortgage penalty is applied on the basis of the greater, of the payment of 3 months of mortgage interest. Or applied as the interest rate differential – the IRD.
When you elect to have a closed mortgage there are limited prepayment privileges. Which range anywhere from 5% to 25% of the principal of the mortgage on an annual basis. Typically there is also the option to increase your mortgage payment by a maximum amount each year. If you go above these limits you will likely incur a mortgage penalty. We typically see mortgage penalties being incurred either from a sale or a refinancing of the property.
Understanding 3 month interest is simple enough to do. However, the interest differential is a little more difficult and of greater concern. Essentially, this is the difference in the amount of interest you would be paying for between the balance of the term of your mortgage and the amount of interest you would be paying if the interest rate were equal to the bank’s current posted rate for the balance of that term.
Seems innocent enough, except for the fact that we have seen interest differential penalties in the tens of thousands of dollars. This can and will potentially affect your return on your property. In some cases has resulted in Sellers having to pay money in order to sell their properties.
What Can Be Done About Mortgage Penalties?
What can you do about mortgage penalties? First, understand what the mortgage penalties are for the mortgage product you are contemplating. Second, understand what your purpose of buying a property is. Are you intending to sell the property relatively soon or hold on to it for longer? Match your term and mortgage product to your intentions. Third, engage your banker or mortgage broker in a full and frank discussion of what your needs are and how prepayment costs can be minimized.
Maybe the best advice of all is to understand what your penalty might be BEFORE you decide to sell or refinance your home.