A sharp decline in mortgage rates in recent months is driving up the cost to break big-bank fixed-rate mortgages.
East Gwillimbury, Ontario, resident Kristina Barybina found this out the hard way when TD Bank charged her nearly $30,000 to terminate her mortgage early.
Barybina, a real estate agent, said she lost most of her income due to the COVID-19 outbreak and was forced to sell her home and break her mortgage.
Barybina was just 19 months into her 5-year mortgage term and had a remaining balance of $591,000.
TD Bank told CTV News that when a borrower breaks their mortgage early, the bank assesses each situation on a case-by-case basis and tries to work with the homeowner to find a solution. In our experience, that means the bank may suggest that you:
- Blend your rate with one of the bank’s current rates to avoid an out-of-pocket penalty (just beware, because the penalty is sometimes built into the new blended rate)
- Port the mortgage to a new property to avoid a penalty
- Make a prepayment to reduce the penalty by 10-20%
Such steps might keep you from paying a penalty out of pocket, but they’ll simultaneously relegate you to paying an inferior rate and being stuck with your lender for longer.
This case was unique in that Barybina might have known better. After all, she was a lawyer and real estate agent who should have been versed in mortgage terms.
Moreover, she reportedly had put the house up for sale once before in November “months before COVID-19 surfaced,” TD told CTV News. “…and the customer did not speak with us about their options until after they sold their home and had discharged the mortgage." (By the way, does anyone else find it odd that a bank is openly discussing a customer’s affairs in public?)
Why Do Banks Charge Big Prepayment Penalties?
This is far from the first time a big-bank borrower has faced the sticker shock of a $10,000+ mortgage penalty.
Last year, as we reported, an Oshawa woman was shocked to be quoted a $15,092 penalty to break her mortgage early, which coincidentally was also with TD Bank. (In the end, this case was resolved by the borrower choosing to port her mortgage to her new property.)
Fortunately, only about 1 in 100 penalties are five figures, according to a Rates.ca survey this past February.
So why do banks charge such high penalties to break a mortgage early? Essentially, it’s a bank’s way of recovering the lost interest income from a client who pays out their mortgage early.
However, one can argue whether those costs amount to $15,000, $30,000, or whatever banks might be charging to profit from the situation. Past studies suggest some IRD penalties are double what is required to make a bank whole.
How are Prepayment Charges Calculated?
Prepayment penalties—or the fees charged when you break a mortgage before the end of its term—come in two forms. For variable-rate mortgages, the penalty is usually three months worth of interest.
Fixed-rate terms, however, are usually calculated based on the higher of three months’ interest, or the Interest Rate Differential (IRD). This is computed based on:
- the remaining mortgage amount
- the customer’s current interest rate and discount
- the rate the lender can charge today if it were to re-lend the funds for the remaining term of the mortgage.
The Perfect Storm for Huge Prepayment Penalties
Because mortgage rates have fallen dramatically in the last couple of months, the growing spread between customers' actual fixed rates and current market rates has led to a significant rise in the size of prepayment charges at big banks. In general, the more short-term fixed rates fall, the bigger big-bank prepayment penalties get on fixed mortgages.
In Barybina’s case, her contracted mortgage rate was 3.75%, far higher than today’s best 5-year fixed mortgage rates.
If she had access to funds temporarily, one way she might have lessened the pain is to take advantage of her prepayment privileges. Most mortgages allow you to pre-pay an additional 10%, 15%, 20% or 25% of the original mortgage value in one or more lump sums each year.
If you’re in a position to make a sizeable payment (perhaps by borrowing off a HELOC temporarily, for example), it can lower the balance of your mortgage, reducing the final prepayment charge accordingly.