When pursuing a career in the mortgage industry, there are crucial concepts you must grasp to succeed as a Mortgage Broker or Mortgage Associate in Alberta. Among these, Mortgage Payout Penalties stand as a vital topic that could appear in your Mortgage Exam. In this blog, we’ll delve into the meaning and calculation of Mortgage Payout Penalties.

What are Mortgage Payout Penalties?

Mortgage Payout Penalties, sometimes referred to as Mortgage Pre-Payment Penalties, encompass fees imposed by mortgage lenders when a borrower:

  1. Breaks the Mortgage Contract
  2. Transfers the mortgage to another lender before the end of the mortgage term
  3. Pays back the entire mortgage before the end of the mortgage term, including selling the house

In any of these scenarios, the lender stands to lose potential future income from the mortgage, prompting them to levy penalties to dissuade borrowers. The terms governing when and how these penalties apply are typically outlined in the mortgage contract provided by the lender.

Types of Mortgage Payout Penalties

Mortgage Payout Penalties come in two main varieties:

  1. 3-Month Interest Penalty
  2. Interest Rate Differential (IRD) Penalty

3-Month Interest Penalty

This type of penalty involves the lender charging the borrower the equivalent of three months’ worth of interest as a penalty for breaking the mortgage term. It is commonly applied to variable rate mortgages.

Interest Rate Differential (IRD) Penalty

In contrast to the 3-month interest penalty, the IRD penalty calculates the difference between the interest rate at the beginning of the mortgage and the current interest rate. The penalty is determined by comparing the mortgage calculated from the differential interest rate with the current interest rate on the remaining mortgage balance. This method is typically used for fixed rate mortgages.

Understanding Prepayment Penalties

Now, let’s explore prepayment penalties, which are another crucial aspect of mortgages:

A prepayment penalty is a fee that your mortgage lender may charge if you:

  1. Pay more than the allowed additional amount toward your mortgage
  2. Break your mortgage contract
  3. Transfer your mortgage to another lender before the end of your term
  4. Pay back your entire mortgage before the end of your term, including when you sell your home

Your lender might use different terms like “prepayment charge” or “breakage cost” for this penalty. It’s important to be aware of when these penalties apply and how they are calculated.

Prepayment penalties can add up to significant amounts, so understanding their calculation is crucial.

What is a Prepayment Privilege?

Prepayment privileges allow you to make extra payments toward your mortgage without incurring a prepayment penalty. These privileges might include:

  • Increasing your regular payments by a certain percentage
  • Making lump-sum payments up to a specified amount or percentage of the original mortgage balance

Keep in mind that prepayment privileges can vary from lender to lender, so it’s important to review your mortgage contract for details.

How Much Prepayment Penalties Can Cost

The calculation of prepayment penalties varies from lender to lender and depends on factors like the amount you want to prepay, the number of months left until the end of your term, interest rates, and the method your lender uses to calculate the fee.

Prepayment penalties are generally determined as the higher of:

  1. An amount equal to 3 months’ interest on your remaining balance
  2. The interest rate differential (IRD)

Lenders usually apply the IRD calculation when your mortgage interest rate is higher than the current interest rate, and you signed your mortgage contract less than 5 years ago. The calculation of IRD may depend on the interest rate in your mortgage contract, which could be a posted rate or a discounted rate.

Tips to Reduce or Avoid Prepayment Penalties

Consider the following strategies to minimize the amount you pay in prepayment penalties:

  1. Maximize your use of prepayment privileges every year
  2. Make lump-sum prepayments before breaking your mortgage
  3. Wait until the end of your term to prepay if the penalty is substantial
  4. Inquire about porting your mortgage when buying a new home
  5. Shop around for mortgage renewal to explore more flexible options

What Your Lender Must Tell You

If your lender is a federally regulated financial institution, they are required to provide specific information. Your mortgage agreement must include an information box at the beginning, detailing prepayment privileges, prepayment penalties, and other essential terms. Your lender is also obligated to explain how they calculate prepayment penalties clearly and transparently.

Before signing your mortgage contract, read it carefully and seek clarification on any terms or penalties you don’t fully comprehend. It’s essential to make informed decisions when navigating the world of mortgages.