Thinking About Refinancing? How a Rise in Posted Rates Could Lower Your Penalty

With mortgage rates now doing a U-turn and heading higher, borrowers are rushing to lock in a rate on a refinance while they still can.

What many experience, however, is disappointment. Specifically, many are discovering that the prepayment penalty for breaking their fixed mortgage early is horrendous. Especially at major banks, penalties can be so large as to negate the benefit of refinancing.

Fortunately, there are strategies to whittle down those penalties. One is to make a prepayment before discharging your old mortgage. Another is to apply for a refinance, set your closing far out, and let rising rates lower your prepayment charge. That’s what we’re going to talk about here.

Understanding IRD Penalties

Here’s an explainer on Interest Rate Differential (IRD) penalties, and how fluctuating posted rates can influence those penalties.

• In a perfect world, IRDs should be based on the difference between your contract mortgage rate and the rate your lender could charge borrowers today — if it re-lent the funds for a term equal to the time remaining on your mortgage.
• Many large lenders, like major banks, don’t do that. Instead, they artificially widen that gap (i.e., increase the interest rate differential) by comparing your contract rate with artificially low “comparison rates” as opposed to their more commonly quoted and realistic “special” or “discretionary” rates. That leads to significantly higher prepayment charges, such as in this recent case.
• As the comparison rate rises, however, IRDs shrink and your penalty drops.

Knowing all of this, we examined how much one might save on their IRD penalty if posted rates were to rise roughly 35 basis points—a very reasonable assumption in a post-recession rebound.

Here’s what we found.

Refinancing now vs. later…a case study

Let’s assume a borrower got a 5-year fixed mortgage three years ago (February 2018). Commonly discounted rates at the time were 3.39%.

We chose the nation’s biggest lender, RBC, for this demonstration, but you could have chosen any big bank.

Here’s an estimate of what a borrower’s IRD penalty would be in this case. We compared today’s rates vs. a scenario where 2-year fixed posted rates rose 35 bps. (We’re using 2-year rates because that’s the term that coincides with the time remaining on that initial 5-year term.)

Scenario 1 Assumptions (IRD penalty at current rates)

• Remaining mortgage balance: $259,452.47 (based on the average new mortgage size from Q1 2018 as per CMHC data, and three years of payments)
• Contract rate in effect: 3.39%
• Discount off the original 5-year posted rate: 1.75% (5.14% - 3.39%)
• Term remaining until maturity: 2 years
• Monthly payment amount: $695.93 (made semi-monthly)

*Calculations made using RBC’s Mortgage Prepayment Charge calculator.

Total Prepayment charge: $10,884.42

That’s a hefty fee to escape a mortgage early.

If you were to wait for the bank’s posted rate to rise 35 basis points, for example, that penalty would drop by roughly $1,777. Mind you, a minority of that would be consumed by your higher interest rate while you wait.

A potential game plan

In order to realize that full savings, however, a borrower would need to get a rate hold at today’s rates before they rise any further. Hence, time is of the essence given the current melt-up in rates.

If you’re able to get a 120-day rate hold on the lowest refinance rates currently available, you’d have four full months to wait and see if posted rates rise. (That’s not a guarantee of course. Rates could unforeseeably drop and increase your penalty.)

Coupled with prepayments prior to breaking the mortgage, this strategy could save you thousands…depending on your mortgage amount.