A mortgage penalty is a fee that a borrower may be required to pay if they break the terms of their mortgage agreement. Typically, this penalty is charged when the borrower pays off their mortgage early or makes a larger-than-allowed payment.
Mortgage penalties are designed to compensate the lender for the interest income they would have received if the borrower had stayed with the original terms of the mortgage agreement. The penalty amount can vary depending on the terms of the mortgage and the amount of time remaining on the mortgage.
It is important for borrowers to carefully read and understand the terms of their mortgage agreement before signing it, including any provisions related to prepayment penalties. Some mortgages may offer the option to pay off a portion of the mortgage early without penalty, while others may charge a penalty for any prepayment.
Bank VS Non-Bank mortgage penalty calculation:
Mortgage penalties are calculated based on the greater of either the Interest Rate Differential (IRD) or three months of interest:
1) Three months interest = interest rate x remaining balance / 12 x 3
2) Interest rate differential = clients current interest rate – current rates for that product x months remaining x balance /12
The IRD penalties a Bank charges can be DOUBLE the size of a Non-Bank lender. This is because they use their posted rates in the calculation whereas Non-Bank lenders use their discounted rates.
Bank IRD Example:
Bob gets a mortgage for $500,000 with a Bank. Their posted rate is 6.34% and they discount it to give Bob a rate of 4.55%, 5 year fixed.
Three years later Bob wants to sell his house and pay off his mortgage. The current 2 year posted rate is 3.89%.
6.34% – 3.89% = 2.45% x $500,000 x 2(yrs) = $24,500 Penalty
Non-Bank IRD Example:
Bob gets a mortgage for $500,000 with a Non-Bank. Their discounted rate is 4.55% which they give Bob, 5 year fixed.
Three years later Bob wants to sell his house and pay off his mortgage. The current 2 year discounted rate is 3.40%.
4.55% – 3.40% = 1.15% x $500,000 x 2(yrs) = $11,500 Penalty