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Clarifying Mortgage Prepayment Penalties

Last month, the federal government published a Mortgage Prepayment Code to ensure borrowers are better informed by lenders (federally regulated institutions) when it comes to situations where mortgage prepayment penalties may be charged – namely, for the purpose of clarifying interest rate differential (IRD).
This is a positive step, because IRD calculations and penalties have traditionally been very confusing to borrowers.
IRD is a charge many borrowers face when paying off a mortgage prior to its maturity date, or by paying the mortgage principal down beyond the amount of annual allowable prepayment privilege limits. And IRD penalties can prove quite costly depending on the remaining mortgage term.
IRD is based on:
  1. The amount that is being prepaid; and,
  2. An interest rate that equals the difference between the original mortgage interest rate and the interest rate that the lender can charge today when re-lending the funds for the remaining term of your mortgage.
Most closed fixed-rate mortgages have a prepayment penalty that is the higher of three months’ worth of interest or the IRD.
The new code requires that lenders “provide the information in language, and present it in a manner, that is clear, simple and not misleading.”
The Code requires lenders to provide, among other things:
  1. Annual Prepayment Information.
    This includes such things as prepayment privileges that the borrower can use to pay off their mortgage faster without having to pay a prepayment charge. Examples include making lump-sum prepayments, increasing the regular payment amount and increasing the frequency of the payment to weekly or bi-weekly. Lenders must also inform borrowers of the dollar amount of the prepayment that the borrower can make on a yearly basis under the terms of their mortgage without having to pay a prepayment charge. As well, an explanation must be provided on how the lender calculates the prepayment charge for the borrower’s mortgage (for example, a certain number of months’ interest or IRD).
  2. Information Provided When Borrower Faces a Prepayment Charge.
    If a prepayment charge applies and the borrower confirms to the lender that the borrower is prepaying the full or a specified partial amount owing on their mortgage, the lender will provide, among other things, a written statement to the borrower including the applicable prepayment charge and a description of how the lender calculated the prepayment charge (for example, whether the lender used a certain number of months’ interest or IRD). If the lender used IRD to calculate the prepayment charge, the lender will inform the borrower of: the outstanding amount on the mortgage; the annual interest rate on the mortgage; the comparison rate that was used for the calculation; and the term remaining on the mortgage that was used for the calculation.
  3. Enhancing Borrower Awareness.
    To assist borrowers in better understanding the consequences of prepaying a mortgage, lenders will make available to consumers information on the following topics: differences between various types of mortgages; ways in which a borrower can pay off a mortgage faster without having to pay a prepayment charge; ways to avoid prepayment charges (for example, by porting a mortgage); how prepayment charges are calculated, with examples of the prepayment charges that would apply in specific circumstances; and actions by a borrower that may result in the borrower having to pay a prepayment charge.
Click here for full details of the code requirements from the federal finance department.
Source: Dominion Lending Centres Inc., April 2012 Newsletter.
The time to understand these terms is when you first apply for your mortgage and before you have made a commitment for the purchase of a home. When you sign your mortgage documents at your lawyer's office as part of the closing process, your lawyer is obligated to go through these items with you too, but by then changing the lender's commitment for your mortgage to terms that are more favourable to you is likely going to cause a delay in the purchase of the home. Understanding if the comparison rate that is used in the calculation is the then current discounted rate similar to what the bank would be offering you, or the then current "posted rate" (which can be up to 2 percent higher) is a really important consideration. Ask questions early.
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