You may be tempted to lock into a fixed mortgage for a five, seven or even 10-year term. This can be a good thing for many Canadian families, however if your life changes due to illness, separation or job loss and you need to break your mortgage you could be hit with a huge penalty.

There has been a general rule that breaking a mortgage usually meant having to pay a three-month interest penalty -- and this formula was often used in the past. Now though banks are more likely to use what is called the "Interest Rate Differential" (IRD) which refers to the penalty the bank will charge if you want out of a fixed mortgage early. Most banks’ policy is based on the greater of either IRD (Interest Rate Differential) or three months interest.

It's important to note that breaking a mortgage can be a good thing if interest rates drop and you want to take advantage of them. You may have to pay a penalty of \$12,000 but could save \$34,000 over time. It's really about calculating the costs to see if it's worth it for your budget.

Key Points:

• ·        Interest Rate Differential is a penalty for early prepayment or breaking of a mortgage is calculated as the difference between the existing rate and the rate for the term remaining, multiplied by the principal outstanding and the balance of the term
• ·        The three factors involved in determining the IRD are the amount of prepayment, the length of the remaining term of the mortgage and the current interest rate associated with the remaining term Most closed fixed-rate mortgages have a penalty that is the higher of three months interest or the interest rate differential
• ·        Variable-rate mortgages do not have IRD penalties

Here is an example of how a lender will calculate the penalty.

Amanda has a mortgage of \$100,000. She is paying 8 per cent and there are three years left on her five-year term. Her outstanding balance is \$97,218. Amanda is considering breaking her mortgage and taking out a new one at 6 per cent interest rates currently being offered. Amanda would have to pay a penalty based on three months interests or the mortgage differential whichever is higher.

The three month interest penalty equals:

Outstanding balance × Monthly interest rate of Amanda's mortgage × 3 months =\$97,218 × (8% ÷ 12 months) × 3 months = \$1,944.The three month penalty equals \$1,944.

To figure out the interest rate differential we take the interest rate on Amanda's mortgage (8%), minus the current market mortgage rate (6%): 8% - 6% = 2% (interest rate differential).

The (IRD) interest rate differential penalty equals:

Outstanding balance × Monthly interest rate differential × months left on mortgage = \$97,218 × (2% ÷ 12 months) × 36 months = \$5,833

The interest rate differential would be \$5,833.

If Amanda wanted to break the mortgage she would have to pay a penalty of \$5,833 since it is the higher of the two calculations. So would it be worth it?

If she stayed with her current mortgage with a 15 year amortization:

\$97,218 mortgage at 8% over 36 months = monthly payments of \$929.07 interest paid over 3 years = \$22,057 Mortgage remaining after 3 years = \$85,829

If Amanda took a new mortgage with a three year term at 6% with a 15 year amortization: \$97,218 mortgage at 6% over 36 months = monthly payments of \$820.38 interest paid over 3 years = \$16,383Mortgage remaining after 3 years = \$84,068

What does all this mean? Well if Amanda decided to pay the penalty of \$5,833 she would save \$5,674 in interest and her mortgage would be \$1,761 less with the lower rate. So Amanda would save about \$1,500 dollars by breaking her mortgage and going with the lower rate,

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hans.taal@century21.ca