A few quick tips to reduce mortgage penalties.
You bought your house a few years ago at an interest rate of 5%. Now everywhere you look banks and credit unions are offering rates of 3% and below on fixed-rate mortgages.
You’ve decided it’s time to get a better deal, but when you speak to your current lender about switching, you get the bad news: you have to pay a mortgage penalty of $5000 to get out of your mortgage, which still has 26 months left in the term.
Now you’re not so sure that it makes sense to switch. Should you resign yourself to continue paying 2% over current rates until the end of your term, or is there something you can do to reduce your mortgage penalty?
Here are a few tips for reducing the penalty when paying out a closed mortgage early.
1) Use prepayment clauses to your advantage.
This is probably the best chance you have for reducing your penalty. It works like this.
Your mortgage penalty is based on your current mortgage balance – how much you have left to pay off. By reducing your balance, you reduce the penalty you pay. If you reduce your balance by 30% (for example, prepaying $30,000 when you have $100,000 left to pay off), then your penalty also goes down by 30%. Therefore, a $5000 penalty would be reduced by $1500 to $3500. It’s that simple.
Most lenders allow you to prepay up to 20% of your original principle balance (how much you initially borrowed) each year. And because that limit applies to a calendar year, you can time payments advantageously if you’re thinking about refinancing in the New Year. All you have to do is prepay 20% just before December 31st and then prepay another 20% in January. You’ve just doubled your mortgage penalty savings.
What’s the catch? You need to have some extra cash to make the prepayment. If you don’t have cash readily available, then you might think about taking out a short-term loan. But what’s the likelihood that your own bank would want to lend you money for prepayment in order to reduce the penalty you owe to them?
So you may have to pull funds temporarily from another source, like family or friends.
One more thing to watch out for is this. Some lenders refuse to consider prepayments 30-90 days before you request getting out of your current mortgage agreement, so check the fine print and plan ahead if possible.
2) Have you had your current mortgage agreement for 5 years or more?
If so, the maximum interest penalty is 3-months interest, because the Interest Act prohibits the (usually much higher) Interest Rate Differential (IRD) calculation from being used.
3) Check that your lender is playing fair.
It’s understandable that your lender is entitled to some compensation for the loss of future interest payments. But while the basic penalty calculation is pretty much the same everywhere (the greater of three months interest or the IRD) the IRD can end up being much higher than you’d expect because the comparison interest rates it uses can be manipulated to the lender’s advantage.
There are plenty of online mortgage penalty calculators floating around these days. Get a rough idea of what you think you should be paying using one of these and compare it to the penalty quote you’re getting from your lender. If the two are massively different, ask your bank manager for an explanation.
If you’re not happy with that explanation, seek advice from the Ombudsman for Banking Services and Investments, which provides free dispute resolution