Mortgage Penalties Coming right up
Mortgage penalties are probably hated about as much as taxes—but tenfold. Particularly when those penalties reach into the five figures.
Take this case of an Edmonton couple that was initially quoted $17,000 to break their five-year fixed mortgage early.
But homebuyers need not fall into the trap of being stuck with enormous penalties simply to break their mortgage early. Particularly when we know that the majority of borrowers do in fact break or refinance early.
“Internal lender statistics suggest that greater than 60% of mortgages will be paid out or restructured at an average of 36 months,” says Dustan Woodhouse, a DLC Mortgage Experts broker and author of Be The Better Broker.
Consider that the mortgage of choice for 68% of the country’s 5.78 million mortgage holders is the five-year (60-month) fixed, and you can see the issue.
As a quick overview, breaking a fixed mortgage entails a penalty that is typically the greater of three-months’ interest or the interest rate differential (IRD). To calculate your potential penalty were you to break your mortgage early, check out this calculator.
No matter how the penalty is calculated, for many borrowers that equates to some serious moola.
Woodhouse says the average penalty he sees is about 4.5% of the balance on a four-year fixed or longer fixed term, while the record was 7.7% with a major chartered bank, on a “significant” mortgage.
“We see absolute devastation when it is 5%-down buyers in a flat or declining market that also paid a 4.15% CMHC premium, and are paying Realtor fees to sell,” he says. “It is costing some of those people tens of thousands to get out of their property. And it could have been avoided.”
How to Avoid Mortgage Penalties
Being informed is a buyer’s greatest defence against punishing penalties down the road.
As Woodhouse puts it, “The greatest danger in our business is not unanswered questions, the greatest danger is unasked questions.”
This is where a broker can come in handy, particularly for unexperienced buyers, as they can help find a suitable mortgage product that balances a competitive rate with the features and flexibility that are right for the buyer, such as a reduced penalty should they need to break the mortgage early.
As we’ve written about previously, many mortgage shoppers tend to put greater emphasis on finding the lowest rate, which may save more money up front, but can potentially cost more over the long run. For example, a typical penalty on a full-featured mortgage would be three months’ interest vs. 2.75% of the mortgage balance for a “low-frills” or discount rate mortgage.
Plan for the Unexpected
Woodhouse says all borrowers need to be realistic about the possibility that they may move or refinance sooner than expected, which is why it’s one of the key discussions he has with his clients.
“The conversation around how pre-payment penalties are calculated are of just about the highest importance when it comes to how I work with my own clients,” he said. “I lead with the topic of prepayment penalties on every client inquiry, within the first 15 minutes or less.”
And while brokers may be able to assist homeowners after the fact, when a mortgage penalty is imminent, he says there is no replacing choosing a mortgage with flexible pre-payment privileges right from the start.
“Once the penalty is in play, there are some techniques for reduction that skilled brokers are aware of, but they rarely reduce it by more than 20%,” he said. “The best strategy is knowing what you are committing to upfront.”
While there are many fixed-rate products that offer flexible pre-payments and fair penalties, another option is to forget about going fixed at all.
Many variable products entail just a 0.50% of balance penalty, which is about nine times lower than the going fixed-rate penalty, Woodhouse notes.
“Life is variable, perhaps your mortgage should be as well,” he says.