Mortgage penalties are back in the news. The government has recently released new requirements for Canadian lenders on how they are to disclose the calculations behind the dreaded Interest Rate Differential (IRD) penalty. These requirements include on-line calculators as well as more disclosure to borrowers on what the penalties will be for early pay-out. This is a great step forward, but exactly how do the lenders calculate the IRD and why doesn’t the government require a common method. Shouldn’t an IRD penalty be calculated the same way no matter what lender? Depends on who you ask. Lenders would argue they have a right to cover their losses in the event that a borrower breaks their contract. Sounds fair, but shouldn’t the losses be similar between similar institutions?
When theory is put into practice you’ll find that different lenders vary greatly in their interpretation of loss. The fairest interpretation would allow lenders to charge the interest lost from mortgages replaced with a similar term mortgage at a lower rate. For example if you had 2 years left on your term with a contract rate of 4% and the lender was offering new clients a 2 year term mortgage at 2.5%, then the IRD would be 1.5% of your mortgage balance for the remaining 2 years. The loophole here is what is the replacement 2 year term? Some lenders have a 2 year published mortgage rate of 4% so the IRD in this example would be $0. Other lenders would argue that although their 2 year published rate is 4% they typically offer a 2 year discounted rate of 2.5%. This is subjective and unfair. If they discount to 2.5% then why not publish that for all of their customers. You can’t have your cake and eat it too. At least you shouldn’t.
If you think that’s bad, you won’t like this. Some lenders take the discount applied on the mortgage when first issued and apply it to the replacement term posted rate. Mortgage insiders know that lenders discount longer term mortgages much more than short term mortgages. This means that an artificially large discount will be applied to the term remaining when calculating the IRD replacement rate. In these cases lenders are charging overinflated IRD penalties. They are not just covering their losses, but profiting on early pay-outs.
With the new disclosure rules in place we can only hope that public scrutiny of the penalties will shame the predatory lenders into limiting their penalties to their losses. Otherwise we’ll have to look to our government to mandate fairness.