Seldom, if ever, have Canadian borrowers prepaid their mortgages as they have in the past 12 months.
"Prepayment speeds have been off the chart," said Jason Ellis, President of Canada's biggest non-bank lender, in a VERICO mortgage broker webinar last week.
Borrowers have scurried to refinance and take advantage of record-low mortgage rates. And that's a good thing ... unless you're a lender.
As we've written many times, mortgage finance companies (MFCs) like First National tend to offer far more favourable prepayment penalty terms on fixed-rate mortgages. Penalties at major banks are often 2-3 times as big, or worse.
But here's the root problem. "Prepayment penalties are supposed to accomplish one simple thing," says Ellis. "That is to remove the economic incentive for renewing or prepaying your mortgage early."
"There shouldn't be a free option to get out of your 5% mortgage and into a 4% mortgage," he adds. Lenders incur too many costs to sell, underwrite, process and fund a mortgage to just let people out of contracts with a weak deterrent.
The idea behind an interest rate differential (IRD) penalty, Ellis says, is that "you pay the difference between those two rates...No one wins and no one loses."
Unfortunately for many lenders — and fortunately for borrowers — some of Canada's most competitive lenders have been the ones losing the most.
Or should we say, losing for now.
There's no free lunch in the lending business. Profit margins have shrunk to extraordinary levels. "It's as razor thin as I've seen it in my 17-year career with First National," Ellis said.
When someone breaks their mortgage, the costs to lenders with fair penalties (as opposed to punitive penalties) considerably exceed the penalty they collect from borrowers. That shortfall may not be sustainable.
We've already seen some lenders revise their prepayment policies in the last year to close this gap. More might follow. So don't be surprised to see favourable prepayment charges, like First National's, become be a slowly dying breed.
