Mortgage refinance penalty
A mortgage refinance penalty is incurred when you make a change to your mortgage before your term is up. In Canada, banks and mortgage lenders calculate this penalty one of two ways: 3 months interest or interest rate differential. Which you pay will depend on your lender, mortgage product, and the duration of your term. For example, while the penalty associated with a variable mortgage rate is always 3 months interest, the penalty associated with a fixed mortgage rate is often the greater of 3 months interest or interest rate differential.
Three months interest vs. interest rate differential (IRD) refinance penalty
| 3 months interest | Interest Rate Differential (IRD) | |
|---|---|---|
| Description | Penalty is the equivalent of three months interest on current mortgage principal | Penalty is the interest lost if your lender were to turn around and lend the funds at today's rates |
| Mortgage Type | Variable and Fixed | Fixed only |
| Formula | [Mortgage principal * original interest rate] / 12 * 3 | [Original mortgage rate1 - current mortgage rate2] * Principal / 12 * months remaining in current term |
| When do you pay? | All interest rate environments | Declining interest rate environments only |
How do you calculate your interest rate differential (IRD) penalty?
Interest rate differential or IRD takes the difference between the interest rate attached to your mortgage and compares it to the current interest rate charged by the lender. Let's look at an example with a home buyer Sarah. Sarah locked in to a 5-year fixed mortgage rate on February 1st 2009 with ING. It is now March 1st 2011, Sarah's mortgage balance is $300,000 and she is considering refinancing.
| Step 1: Determine your current mortgage principal, original mortgage rate and provider | $300,000 mortgage 5.49% original mortgage rate Mortgage provider is ING |
| Step 2: Determine the length of time remaining in your mortgage | = 5 years - 2 years, 1 month = 60 months - 25 months = 35 months (close to 3 years) |
| Step 3: Determine your lender's current mortgage with a term equal to your remaining term | ING current 3-year fixed rate = 3.89% |
| Step 4: Subtract the lender's current mortgage rate from your original mortgage rate | = 5.49% - 3.89% = 1.60% |
| Step 5: Multiply the difference in interest rates by principal and divide by 12 months | =[1.60% * $300,000] /12 months =$400 |
| Step 6:Multiple the monthly fee by the number of months remaining in your term | = $400 * 35 months - $14,000 |
How do you calculate the 3 months interest refinance penalty?
The 3 month interest penalty is more straightforward than the interest rate differential. Simply take your current mortgage principal and multiply it by your current mortgage rate, divide by 12 months to get a monthly penalty and multiple it by 3 to account for three months. Let's consider the same example, where Sarah locked in to a 5-year fixed mortgage rate on February 1st 2009 with ING. It is now March 1st 2011, Sarah's mortgage balance is $300,000 and she is considering refinancing.
| Step 1: Determine your current mortgage principal | $300,000 |
| Step 2: Determine your original mortgage rate | 5.49% |
| Step 3: Determine one months interest payment | [$300,000 * 5.49%]/12 months = $1,372.50 |
| Step 4: Multiply one months interest by 3 | $1,372.50 * 3 months = $4,117.50 |
| Result 3 months interest penalty | $4,117.50 |
Minimize your refinance penalty by taking advantage of your pre-payment options
Most mortgages come with pre-payment options which allow you to put a lump sum against your mortgage each year and/or increase your monthly payment. Putting a lump sum against your mortgage and increasing your monthly payments both have the ability to decrease your mortgage principal and therefore your penalty. Therefore if you are refinancing now or in the near future, it is important to take full advantage of these.
References and Notes
- Original mortgage rate is the interest rate you are currently paying with your lender (before refinance)
- Current mortgage rate is your lender's current interest rate on a term equal to remaining time in your term