My wife and I recently considered selling a small condo that we purchased in Montreal some eight years ago. The four-year fixed mortgage we have on the asset is of about $200,000, with an annual interest rate of 3.24 per cent.
In retrospect, going with a variable rate would have been a much better choice, but back then, securing a 3.24 per cent rate seemed attractive enough.
We knew that paying off the mortgage in full — a year and a half before it is up for renewal — would trigger some penalties, but when I inquired with Bank of Montreal what would be the exact amount, I was stunned to learn that the penalties would amount to $6,717.
You read it right, a penalty of almost $7,000 for breaking a small mortgage of $200,000 only 21 months before maturity.
How could that be? I asked. What I had in mind is a general rule of thumb that the penalty for breaking a mortgage early equals three months of interest. In our case, this would have cost us about $1,700 in fees. But $7,000?
I looked at my mortgage statement more carefully and realized that I was caught off guard when I renewed it a couple of years ago.
Our rate was indeed locked for four years at 3.24 per cent, but it was defined as BMO’s “posted rate” at the time we took the mortgage – 4.89 per cent – minus a “rate discount” of 1.65 per cent.
In a case like ours, as long as the mortgage matures according to plan, no special penalties will kick in. But if paid early, that “discount” that we received off the posted rate could actually turn out to be quite expensive.
By applying the “Interest Rate Differential” (IRD) — a somewhat complicated calculation that few borrowers fully understand — big banks charge massive penalties that could reach as much as five per cent of the loan (or principal) value.
To be fair, banks should receive some compensation when a client pays a mortgage in full before maturity. When a bank is initiating a mortgage, for example, providing a five-year fixed-rate loan, it’ll typically hedge (eliminate) its interest rate risk by getting into an opposite position to the one it provided to the customer.
If the mortgage is paid in full prematurely, say after three years, the bank will have to cover its hedged position it held against the mortgage. If interest rates change, this could expose the bank to a loss, and the penalties compensate the bank for that loss.
But the way in which Canadian banks are calculating these penalties results in excessive and unfair fees.
In Canada, the Big Six banks have multiple menus of mortgage rates. First, there are the so-called “posted rates.” These rates are typically inflated and should be considered as a sticker price for a new vehicle — a rate that no one should ever pay.
Currently, the Big Six banks’ posted rate for a five-year fixed mortgage is 4.79 per cent. The rate is significantly higher than the Government of Canada five-year bond yield which stands at 0.87 per cent — a good proxy for how much it costs the bank to finance the mortgages they provide.
Then, there are the big banks’ “special rates” or “best available rates” which are the competitive rates that you should aim to lock-in. The five-year fixed special rate at the Big Six is about 2.44 per cent now. This means that banks are willing to initiate five-year fixed mortgages at 235 basis points below their posted rates, which makes you wonder, why are posted rates so high?
If you do your research and negotiate, the big banks will offer you a competitive rate, far below their posted rate. But almost always, they will still link your discounted rate to the posted rate in a way that will trigger higher fees in case you break the mortgage early.
Robert McLister is a mortgage expert and editor at RATESDOTCA. He has been studying the Canadian mortgage market for years. “If you’re asking me, can you get a five-year fixed mortgage from a major bank without any chance of paying high penalties, the answer is definitely no,” he tells me in a phone interview.
There is a good reason why the five-year fixed rate — by far the most popular among Canadians — is so overblown. The IRD, the formula that generates high penalties for the banks, is larger, the higher the difference between the posted rate at the time a mortgage was initiated and the bank’s posted rate with remaining term (for example, two years fixed) when the mortgage is prepaid.
Since the majority of mortgages in Canada start off as five-year fixed, it’s beneficial for the banks to keep the five-year posted rate artificially high.
Mortgage Professionals Canada, the country’s mortgage industry association representing more than 13,000 individuals and more than 1,000 companies, confirms this observation.
In its recent publication, Annual State of the Residential Housing Market in Canada 2020, the association highlights the huge gap between the average posted five-year mortgage rate (4.95 per cent) and the average mortgage interest rate (2.25 per cent), and concludes: “It confirms that, increasingly, the banks’ posted rates are not being set in reference to the actual marketplace.”
Hence, according to Canada’s mortgage professionals, the big banks’ posted rate is basically a scheme.
Lack of competition is one of the reasons why this is possible, according to McLister. “In Canada, we have six big banks that control, directly or indirectly, over four out of five mortgage dollars through funding and direct origination. Most countries don’t have that level of concentration of the banking system,” he explains.
So what should you do the next time you need a mortgage?
The best way to avoid paying high prepayment penalties is to choose a variable-rate mortgage. Then, in most cases, banks would charge you just three months of interest for breaking a mortgage early, which is fair.
But in the current low interest rate environment many are rightfully tempted to lock in a five-year fixed rate. In that case, choose a lender that has just one set of discount rates. Tangerine (owned by Scotia) is one good example. That way, even if you break your mortgage early, penalties are going to be much more reasonable.