Ellen Roseman: If you plan to break your mortgage, beware the penalties

Mortgage rates have plummeted in Canada since the COVID-19 pandemic and you can find some eye-popping rates. 

Suppose you plan to buy a home and put down less than 20% of the purchase price (known as a high-ratio mortgage that insures the lender against default). You can find a five-year fixed-rate mortgage at a historically low rate of less than two percent.

Or suppose you already have a five-year fixed-rate mortgage. You might want to break your current mortgage contract before the term ends and lock in an attractive rate before it disappears.

Here are some warnings, based on my experience covering Canada’s mortgage market for many years: 

• Don’t shop around only for rates. The money you save on a five-year fixed-term mortgage may be wiped out by the penalty you’re charged to make an early exit from your mortgage contract.
• Ask how much you’ll pay to ditch the mortgage before the five-year term ends. The penalty may be much higher than you expect, especially in the first year or two. 
• Find out how the penalty is calculated. Big banks have been the subject of  class action lawsuits across Canada for the way they calculate — or miscalculate — their mortgage prepayment penalties.

CBC Go Public recently told the story of an Ontario woman who was forced to sell her house when her income dried up. She was only 19 months into a five-year mortgage, with a fixed rate of 3.71%, and still owed $591,000. Her bank used a controversial calculation and said she owed a penalty of almost $30,000 for breaking her mortgage.

When you sign up for a mortgage, breaking it is probably the last thing on your mind. But sometimes you have to act fast because you get sick, lose your job, or accept a promotion in another city.

“In Canada, where the five-year fixed-rate mortgage reigns supreme, about 70% of people change their mortgage before the end of its term,” says Sean Cooper in Burn Your Mortgage, a book he wrote after he bought a Toronto house at age 27 and paid off the mortgage within only three years. 

Given that the odds are stacked against you, Cooper advises, take the time to ask your lender about any penalties before signing up for the mortgage. Penalties are designed to compensate the lender for lost interest.

How penalties differ based on mortgage type

In Canada, the type of penalty depends on whether you have a variable-rate or a fixed-rate mortgage. With a variable-rate loan, you’ll pay a penalty of three months’ interest. With a fixed-rate loan, you’ll pay the greater of three months’ interest or the Interest Rate Differential (IRD), which is calculated by looking at current mortgage rates and your remaining mortgage balance. 

Cooper gives an example using a borrower called Samantha. She buys a condo in Calgary and gets a five-year fixed-rate mortgage. Two years later, she accepts a job offer in Toronto and decides to sell her condo and rent in her new city.

• Samantha has a 2.99% five-year fixed-rate mortgage, with an outstanding mortgage balance of $300,000. Using three months’ interest, her penalty would be: 2.99% × $300,000 × (3 months/12 months) = $2,243.
• But since she signed up for a five-year fixed-rate mortgage, she also must calculate her penalty using the IRD. Although her mortgage rate is only 2.99%, her lender uses the rate of 4.79%, the posted rate at the time she signed up for her mortgage, to calculate the penalty.
• Samantha has 36 months left on her mortgage. Her lender’s current three-year fixed mortgage rate is 3.59%. Using the IRD, her penalty would be: $300,000 x 36 months x 2.20% (the difference between 4.79% and 2.59%)/12 months = $19,800.

“Since the IRD in this case is greater than three months’ interest, Samantha would have to pay nearly $20,000 (the price of a new car) to break her mortgage,” says Cooper. “This is why it’s crucial to ask about mortgage penalties before signing up for your mortgage.”.

How to avoid a penalty for breaking your mortgage 

The last thing you want to do is deplete your home equity when you decide to break a five-year fixed-rate mortgage. Here are some tips on how to sidestep that. 

• Look beyond the bank. Cooper started with his local bank, but after shopping the market with a mortgage broker, he ended up signing with a non-bank lender that gave him a lower rate, better prepayment privileges and a less costly penalty for breaking his mortgage. “Non-traditional lenders with a solid track record are worth considering, especially if it means paying down your mortgage sooner,” he says. It also helps to compare mortgage rates online.
• Look for fair penalty lenders. A fair penalty is a mortgage prepayment charge that reasonably compensates the lender if you break your mortgage contract before maturity. 
• Look for online calculators. The Financial Consumer Agency of Canada shows you how to estimate your prepayment penalty using three months’ interest and the IRD. You can also use LowestRates.ca’s mortgage calculator. 
• Look beyond a five-year fixed-rate mortgage. You need to evaluate your circumstances and map them against possible scenarios — the end of a relationship, income loss, debt accumulation, moving somewhere new, or the desire to refinance to pay for a home renovation, says mortgage agent Ross Taylor. If you foresee changes, consider a variable-rate mortgage with a fixed payment. This means you pay more interest and less principal when the prime rate rises and vice versa when the prime rate falls. 
• Look for the Bank of Canada’s guidance. In a July 15 press conference, BoC Governor Tiff Macklem said this is not a normal recession and it will take a long time for economic activity to get back even to the level where it was at the end of 2019, before the pandemic struck. “We are being unusually clear that interest rates are going to be low for a long time,” he said. 

Should you choose a fixed or variable-rate mortgage?

It is unusual for a central bank with a conservative reputation to be so clear about where rates are headed, said mortgage broker David Larock in a July 20 update. The Bank of Canada wants to see evidence of a full recovery before raising rates. That could easily take until late 2022/early 2023, which would put us about three years from the start of the crisis.

Larock believes that a five-year variable-rate mortgage is “the slam dunk option” for borrowers who are prepared to live with the remote risk that rates will rise sooner than is now expected (since that risk will never completely go away). Here are his reasons to support a variable-rate mortgage:

• Today’s variable rates are lower than their fixed-rate equivalents and don’t appear likely to rise any time soon.
• Variable rates come with a free option to convert to a fixed rate at any time. And if fixed rates continue to fall as expected, you may be able to convert down to a lower fixed rate later.
• The penalty to break most variable-rate mortgages is only three months’ interest, while fixed-rate penalties are calculated using the greater of three months’ interest or the potentially expensive IRD penalty.

As for Sean Cooper, he’s now licensed as a mortgage broker and tries to make clients aware of the penalties that can arise with five-year fixed-term mortgages. But he finds it hard to grab their attention.

“Most people learn about these big penalties the hard way when they break a mortgage,” he says. “If I don’t mention the penalty to clients, they don’t think about it at all.”

About 10 years ago, the federal government said it would insist on standardized mortgage penalties and not allow the big banks to use their own quirky methods of calculating them. That promise was never kept. Instead, the big banks had to provide more disclosure of penalties in their contracts and online.

In my view, consumers won’t get the message without being given real-life examples of what can happen when they break a mortgage, delivered in plain language without jargon or technical terms. We’re still waiting.