WHAT IS THE INTEREST RATE DIFFERENTIAL (IRD) PENALTY?

If you choose a fixed mortgage term and need to pay out or refinance during your term you will be faced with an interest rate differential (IRD) penalty.  A mortgage is a contract and if you break your obligations, the lender expects to be compensated.  Be fair warned though, not all lenders calculate the interest rate differential the same which can lead to massive variances to your potential penalties. 

For us to understand how IRD penalties are calculated we need to look at an example.  The two most popular interest rate differential (IRD) calculations used are the standard IRD calculation and the posted rate IRD calculation.

It’s important to note that the penalty is the greater of 3-months interest (penalty for variable rate mortgages) or the interest rate differential (IRD) calculation.

For our example, let’s assume our client, “Jane Doe”, has a 5-year fixed rate of 3.6% with a balance of $450,000 and has 36 months remaining in her term.  Jane needs to sell her home as she took a new job in another city.

3 Months interest is simply: ((balance x rate) / 12) x 3 = 3 months interest

(($450,000 x .036) / 12 ) x 3 = $4,050 is the three months interest penalty

STANDARD IRD CALCULATION 

This method calculates your penalty using the lender’s current rate that most closely matches your remaining term.  There is no “discount” to this rate and can be found by looking at your lender’s published rates.  This method is commonly used with monoline (Broker) lenders and most Credit Unions.

Jane has 36 months remaining in her term so we use the current 3-year fixed rate being offered by her lender to calculate her IRD.   The 3-year fixed rate is 3.00%

IRD = ((current rate – lender’s rate that matches your remaining term)/12) x mortgage balance x remaining term in months

IRD = ((.036 – .030) /12) x $450,000 x 36 = $8,100 (1.8% of your mortgage balance)

The standard IRD penalty of $8,100 is greater than the 3-months interest of $4,050 so you pay $8,100.

POSTED RATE IRD CALCULATION

This calculation is easy to manipulate and is used by all the major Banks. Buried in the fine print of your mortgage commitment, the IRD used will be calculated using the lender’s “posted rate.”  This is a very important difference as you will see.  Banks post much higher rates of interest and then tell people they are receiving a “discount” on their mortgage which isn’t true at all.

At the time of Jane’s mortgage, the 5-year posted rate was 5.10% and she was given a “discount” of 1.5%.  This is how this lender got to her actual rate of 3.60%.  In the lender’s eyes, she was given a discount of 1.5% and this must be used to calculate her IRD penalty.

Let’s say the lender’s posted 3-year fixed rate is currently 3.30%.

IRD = ((your actual contract rate – (lender’s POSTED 3-year rate – original “discount”)) / 12) x mortgage balance x remaining term(months)

IRD = (.036 – (.033 – .015)) /12 x $450,000 x 36 = $24,300 (5.4% of your mortgage balance)

Your penalty just tripled because you signed on with a lender that uses posted rate interest rate differential penalties. 

Are you still wondering how the Big Banks make record profits seemingly every quarter?  The worst part is, the Banks control their own posted rates meaning they control the size of your potential penalty.

Make sure you discuss all your options with your Mortgage Broker. Whenever possible, always opt for a lender that uses the standard interest rate differential calculations.  It could potentially save you thousands of dollars!