Mortgage Penalties… How They Should Be Calculated
Let me say this first, before we get to the whole rip-off thing…
Mortgage penalties are necessary. The bank has to protect their investment if you were to end up breaking off the mortgage early.
I mean, this makes sense. It’s the nature of a loan.
What doesn’t make sense is when a bank uses a RIDICULOUSLY ONE-SIDED penalty equation to essentially rob you of money.
We’re going to use the example of one our members, who, as I mentioned before, was over-penalized by $15,000.
There’s a little math in this post, but I’ll do my best to explain it simply.
If you don’t slow down and figure out this stuff, I guarantee it will come back to bite you on your own mortgage.
The Penalty… Calculated Fairly
One of our members was putting their home up for sale earlier this year because they needed to move for work.
Their original 5 year mortgage was taken out in August of 2013, directly with their bank, with a rate that I’m sure at the time was a deeply discounted 2.89%.
Here’s how their penalty should’ve been calculated, if the bank was honest about calculating their penalty.
Here’s the equation:
[(your rate) – (the current market rate for however many years you have left)] X (number of years left in term) X (Mortgage amount)[2.89% – 2.34%] X 3 X $446,770.84 = $7,371.72
For people who freak out when they see equations: let me break this down.
Honest lenders start by taking the difference between your rate and the current market rate for however long you have left on your mortgage (for example a good lender today would give a 2.34% for a 3 year mortgage).
So, your current rate= (2.89%) MINUS (Market rate for a 3 year term: 2.34%)
We call the difference between (2.89% – 2.34%) the “multiplier”. The bigger the multiplier, the bigger the penalty.
(The banks call this the Interest Rate Differential, or IRD. We’ll call it “multiplier,” because that’s easier.)
And, if fairly calculated for this mortgage, it’s 0.55%. Or .0055 (we moved the decimal over twice – remember that from high school?)
Next you take this .0055 multiplier and…multiply it….by the number of years left in the term and the actual mortgage balance you have remaining.
Basically, what they’re trying to do is have you make up the interest they’re losing from you getting out of the mortgage early.
Which, like I said, is totally something they should do. If they didn’t, they would go out of business fast.
The problem for our member, and the reason they reached out to us, was that they didn’t pay the $7,371.72 penalty.
They paid over $22,000.
And it’s all because of the way that most big banks manipulate and skew the numbers in their favor.
Above you can see the statement our members sent us…
First, take a look at the column on the left, at “Interest Rate Discount Received.”
In their case according to their form, when they first got their mortgage they received a 2.10% rate discount…except….that’s incredibly deceptive.
In order to believe they received a 2.10% discount at the time, this means that Scotiabank in fact was charging people 4.99% for a five year mortgage in 2013!
That’s a ridiculous rate. It would have NEVER happened in the marketplace because it’s so far from competitive. If you look at the graph on this page you can see that the average discounted, competitive rate during that year was 2.84% for a 5 year mortgage.
Therefore the 4.99% rate is an arbitrary, made up, Easter Bunny, Santa Clause number. It doesn’t exist.
ALL MAJOR BANKS DO THIS AND WE’LL SHOW YOU WHY
If you take a quick look at all the major banks, they all have a “posted rate” of 2+% higher then the actual rates they compete on in the marketplace.
Why do you suppose they do that?
Because it allows them, legally, to take thousands of dollars from your pocket.
Remember our original equation?
[2.89% – 2.34%] X 3 X $446,770.84 = $7,371.72
Remember, in our equation, that multiplier (the number in the brackets) came in at .55%. Or .0055.
At some point, the banks decided that using that multiplier wasn’t good enough. The bigger the multiplier, the bigger the penalty. So here’s what the bank’s equation looks like:
In other words: [Your rate – (current posted rate for a comparable three year term – discount received initially)] x (number of years remaining) x 445,770.84 =
Let’s break this down:
“Your rate” still equals 2.89%. That stays the same.
The second part is where things get sketchy. Their “current posted rate for a three year term” came in, for this case at 3.39%. It’s a high rate, but not outrageously so. But watch this abra-cadabra magic the bank is about to pull.
That second number? Discount received initially?
It’s the return of the 4.99% rate. They’re using the same “discount” from their arbitrary posted rate AGAIN.
This looks like:
2.89% – (3.39% – 2.1%)
2.89% – 1.29% = 1.6% …………… Compared to the 0.55% multiplier we used in the fair calculation.
LADIES AND GENTLEMAN, BOYS AND GIRLS, STEP RIGHT UP TO SEE A MULTIPLIER TRIPLE IN SIZE…
AND, AS A RESULT, TRIPLE THE PENALTY.
The difference here is obvious. Plug in all those numbers (we didn’t even get into them using the 3.42 instead of 3 years for the number of years), and you come up with a grand total penalty of $24,447.30.
But wait, there’s more!
In this specific case, Scotia Bank allows leniency in calculating their penalties, so they actually end up discounting our member roughly $2,000.
How nice of them.
The Bank’s Answer:
Obviously, this is an unfair system.
It gets worse…in this article from the Financial Post Laura Parsons, Calgary area manager for Bank Of Montreal actually said this….“You really have to understand what penalties (sic.) are,” said Ms. Parsons, who agrees that many people do not. “There is a responsibility of clients to read their documents but also for the lawyers to explain all the terms and conditions.”
In theory, I guess one could argue that she’s correct. But I believe, and I think most Canadians would as well, that when we are talking about such a potentially expensive feature of a mortgage, that maybe the bank people, like Laura and her employees, ought to show people this when they are shopping.
Of course, this idea is laughable. “Knowing” the bank does this is in no way addressing the issue, and for Ms. Parsons to claim that it’s the customers responsibility to avoid being screwed is a poor line of logic.
“So What Should We Do?!”
Take a deep breath. Put down the pitchforks.
First of all, there are many lenders that don’t charge penalties like this. Many of them (not the big 5 banks), still calculate penalties the old-fashioned, FAIR way. In fact, check out the image below. It’s a penalty comparison for one of our members that highlights the difference between all of the big 5 banks and the lender that we placed them with:
Second of all, EVERY single Canadian reading this blog post must ASK their bank employee to walk them through the penalty calculation that will happen if they were to pay the mortgage off early. Then, compare that to the other lenders they are shopping with, and factor that in when choosing their lender… not just the Interest rate they are charging.
Remember, a good rate could save you a maximum of 1k in 5 years, but it’s not worth it if the penalty is 15k more.
The Angela Calla Mortgage Team is here to help youensure you have the best possible mortgage call us today to avoid these expensive mistakes 604-802-3983 firstname.lastname@example.org