IRD Penalty... Say What
Rob McLister - Canadian Mortgage Trends
Apr 15, 2011 - 8:58:35 AM
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If you decide to payoff your mortgage and refinance or you won the lottery often people are surprised (shocked) to find out what it costs to get out of their mortgage. The standard calculation is called an Interest Rate Differential (IRD). However the the way this IRD is calculated is far from standard and often confusing to consumers. Below is our attempt to shed some light of this mysterious calculation!
IRD Penalty Comparison Rates
The much-unloved Interest rate differential (IRD) penalty is a mystery to most of the natural born population.
People loathe it, largely because they don’t understand it. We
continually come across folks who read their entire mortgage contract
and are still confused by the IRD calculation.
Fortunately, federal disclosure guidelines are on their way later
this year. These guidelines are supposed to standardize the explanations
of IRD penalties to make them more comprehensible.
There is one element of the IRD calculation, in particular, that gets
people all tied in knots. It’s called the “comparison rate.”
Here’s a real-life example of how the comparison rate can spoil your day: Customer fee to pay out mortgage doubles (CBC News).
The story features a regular guy (Mohsen Movahed) who learned how to calculate an IRD penalty…the hard way.
It seems Movahed relied on a penalty quote, only to find some months later that his penalty had doubled.
The culprit, says his bank, was the comparison rate used in the IRD calculation.
A comparison rate is the rate a lender compares to your current contract rate in order to calculate the IRD penalty on a fixed-rate mortgage.
The comparison rate is usually the lender’s rate for the term that most closely matches your remaining term.
For example, if you have 22 months remaining on your fixed mortgage, a
lender will typically (there are exceptions) use a 2-year term as your
comparison rate.
The kicker is that banks often subtract the discount you received at origination from their
posted (comparison) rate—which makes the interest rate differential and penalty even worse!
Some lenders use bond yields for their comparison rates (example). This method can sometimes be far more costly depending on yields and mortgage spreads.
Conversely, some non-bank lenders use regular discounted rates for
their IRD calculations, which can be more favourable for the customer.
In any case, Mr. Movahed discovered that the comparison rate can drop
considerably as time goes by. That drop can boost the interest rate
differential and cost you thousands more.
As a sample test, we ran a quick penalty calculation for breaking a
hypothetical $250,000 mortgage. Our example was based on actual
historical and current bank rates. It assumed the customer had about 2.5
years remaining on their term and had received a 1.50% discount off
posted rates.
Depending on the effective date of the penalty calculation, a bank
could quote the penalty based on either a 2-year or 3-year comparison
rate. That’s relevant because the penalty difference between these two
comparison rates (as of today March 24, 2011) is more than $3,700!
In other words, if our hypothetical customer waited until she had
slightly less than 2.5 years remaining in her term, the bank could apply
the lower 2-year comparison rate (instead of a 3-year) and her penalty
would increase 28%. (A lower comparison rate makes the IRD bigger.)
The moral is that timing matters when calculating an IRD penalty. A
good mortgage advisor can help you plan properly to minimize the IRD, if
and when you have to pay it.
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