Over the past few years many Canadians considered breaking their mortgages early to take advantage of lower interest rates, but were faced with expensive and complicated penalties to do so.
These high refinance penalties may still take away much of the incentive to break your mortgage, but at least now the government is forcing banks to outline how the penalties are calculated.
The Canadian Bankers Association (CBA) recently announced a new Code of Conduct that will be implemented over the next 6-12 months requiring lenders to make clear disclosures regarding prepayment options and refinance penalties.
Currently, the inputs (all applicable interest rates, terms and balances) used to calculate refinance penalties and the formulas of the calculation are not clearly outlined by lenders, masking the hidden costs of refinancing. The penalty is usually the greater of three months interest or what is known as the Interest Rate Differential (IRD). The IRD is where the penalty formula gets fuzzy, as it is supposed to capture the lost revenue to the lender of breaking your mortgage contract early. Clearly – or not so clearly, rather – this is open to interpretation and the calculations vary significantly. [For a more detailed explanation on how the IRD is typically calculated, in theory, see this post]
Thankfully, the government has recognised the lack of consumer protection here, and going forward federally regulated lenders must make the following disclosures:
- The exact formula and method for calculating prepayment charges that is “clear, simple and not misleading”
- A description of the inputs used (mortgage rates, terms and outstanding balances) and where to obtain these inputs
- An outline of the available prepayment allowances that do not incur prepayment charges (for example, making lump-sum prepayments, increasing the regular payment amount, and increasing the frequency of the payment to weekly or bi-weekly)
- A 1-800 number to an informed customer service representative who will guide borrowers through exact prepayment penalty calculations
- Calculators on their public websites that provide reasonable estimates of penalties
The last requirement, the refinance calculators, undoubtedly has the potential to be the most useful to consumers in clearly obtaining the associated charges of breaking your mortgage.
Other important factors to note:
- This information is provided annually or in a written statement when you refinance
- These guidelines do not apply to credit unions and other non-federally regulated lenders
- The regulations will require banks to show how they arrive at a mortgage prepayment penalty, but do not standardize the calculation method. This is an important distinction
It will be interesting to see how these new changes will affect borrower behaviour. It’s possible more will consider refinancing given the proper tools and more will compare different lenders based on how they calculate refinance penalties. The latter may even result in lenders adjusting penalty calculations to meet the demands of a more competitive market.
On the whole, it is a big step forward in promoting financial literacy and advancing consumer protection in the mortgage market.