 Mike Toporowsky AMP
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| Interest Rate differential (early payout penalties for your mortgage) |
Monday, May 10, 2010 |
Interest Rate Differentials and why they should concern you
IRDs are a pre-payment penalty tacked on your mortgage payout, if you pay it off early.
They are generally meant to discourage a mortgage holder from breaking a higher rate mortgage in favour of moving it to a lower rate. The lender is trying to protect its investment portfolio.
I have included the formula for calculating IRDs and interest penalties below, however there have been some changes to some lender documents over the past couple of years that you should be aware of.
In the past couple of years, some lenders have included the expensive IRD penalty in ‘all’ early payout scenarios. That even includes a bonafied sale of a property. Your mortgage broker should be able to advise you if your new mortgage is affected with this change.
Imagine the grief if your employer asked you to move and your mortgage restricted you from selling your property until the renewal date. So make sure your mortgage strategy matches your potential needs.
Most all mortgages in the past had a clause like. “your mortgage is open to early payout on payment of either an IRD or a 3 month interest penalty…whichever is greater; except on the proof of a bonafied sale of the property where the penalty would be 3 months interest”.
Interest Rate differentials generally only apply when interest rates are low, because by definition they become non-effective when the rates rise higher than your current mortgage rate.
Examples show readers how a complex concept or calculation works
Sometimes, the best way to communicate information is to explain it and then give an example to show how it works in practice. In the following example, the costs of paying off a mortgage debt early, before the mortgage maturity date, are explained; readers are offered a step-by-step formula to use; and then, an example illustrates a “typical” situation.
Costs of paying off all or some of your closed mortgage before the maturity date
Costs of making a pre-payment
The cost of paying off all or some of the remaining principal amount of your closed mortgage before the maturity date is the higher of these two amounts:
(1) three months’ interest costs on the amount you want to pay
or
(2) the interest rate differential amount. This amount is the difference between your existing mortgage interest rate and the interest rate currently charged for a mortgage similar to yours, calculated for the remaining term of the mortgage less any discount you received on your existing mortgage. A mortgage similar to yours has a term that is closest to the remaining term of your existing mortgage.
How to estimate pre-payment costs-
Here is how you can estimate the cost of paying all or some of the principal amount of your mortgage before the maturity date. The result you get will only be an estimate. We use a precise formula that credits you for the amount of principal you would have paid off each month.
3 months’ interest costs
(1) To estimate the three months’ interest costs
Change your yearly interest rate from a percent to a decimal. For example, 6% = .06; 12% - .12. Multiply this number by the amount you want to pay. Then, divide the result by 4. The answer is the estimated three months’ interest costs.
Step 1: _______ (A) - amount you want to pay
_______ (B) - mortgage interest rate written as a decimal
_______ (C) - A x B = C
Step 2:
_______ (D) - C ÷ 4 = D, estimated three months’ interest costs
(2) To estimate the interest rate differential amount
Interest rate differential Follow these steps to estimate the interest rate differential amount.
interest rate differential Step 1:
_______ (A) - annual interest rate on your mortgage
_______ (B) - current annual interest rate for a new mortgage with a term that is closest to the remaining term in your existing mortgage (less any discount you received on your existing mortgage)
_______ (C) - A - B = C, which is the difference between your existing interest rate and the current rate
_______ (D) - amount you want to pay off
Step 2:
_______ (E) – number of months left until your mortgage maturity date
_______ (F) - (C x D x E) ÷ 12 = F, estimated interest rate differential amount
The estimate cost of paying off all, or some, of the principal amount remaining on your mortgage before the mortgage maturity date will be the larger number that results from the calculations in (1) and (2).
It is strongly suggested that you contact your lender for an exact payout. Their payout may be done through a computer calculator and numbers may vary slightly.
Example
Here is an example to illustrate the cost of paying off a mortgage before the maturity date.
Fiona and Henry have a mortgage for a 5-year term. The interest rate is 9 per cent. The original amortization period was 20 years and there are 18 years remaining. They still owe $100,000. They have inherited $100,000 and are thinking of using it to pay off their mortgage. They have used all the pre-payment options available to them this year. There are 36 months left before the mortgage maturity date. The current interest rate for a mortgage with a similar term is 6 per cent.
Three months’ interest costs
Step 1: $ 100,000 (A) - amount they want to pay
. 09 (B) - mortgage interest rate written as a decimal
$ 9,000 (C) - A x B = C (100,000(A) x .09(B) = $9,000(C)
Step 2: $ 2,250 (D) - C ÷ 4 = D, ($9,000(C) ÷ 4 = $2,250(D)
(estimated three months’ interest costs)
Interest rate differential amount
Step 1:
9% (A) - annual interest rate on the mortgage
6% (B) - current annual interest rate for a new mortgage with a term that is closest to the remaining term in their existing mortgage (less the discount received on their existing mortgage)
.03 (C) - A - B = C, the difference between their existing interest rate and the current rate, written as a decimal
$ 100,000 (D) - amount they want to pay off
Step 2:
36 months (E) - number of months left until the mortgage maturity date
$ 9,000 (F) - (C x D x E) ÷ 12 = F (.03(C) x 100,000(D) x 36(E)) ÷ 12 = $9,000
estimated interest rate differential amount
In this example, Fiona and Henry estimate that it would cost them $9,000 to pay off their mortgage before the maturity date, since this amount is higher than the three months’ interest costs. When Fiona and Henry check with us, they would get the exact cost of paying off their mortgage early. In their case, the exact cost would be lower than their estimated cost.
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posted by MIke Toporowsky at 8:07 am |
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| 1 comments - Add comment |
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| tanygeo said... |
Tuesday, April 27, 2010 @ 11:34 pm |
| i like this particular article. it gives me an information around the world thanks a lot and keep going with posting such information.
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Finance |
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Mike Toporowsky AMP
Real Mortgage Solutions
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