Monday, June 1, 2009

Interest Rate Differential on Mortgages

When homeowners try to break a fixed-rate mortgage, they can be blind-sided by a whopping interest rate differential (IRD) penalty. It’s important to understand what you are agreeing to when you sign for a mortgage.

Periodically, your bank will send you a statement telling you what your current mortgage balance is, but this balance is not an accurate reflection of your obligation to the bank. To understand this, consider the following fictitious example.

Bob and Sue Ward bought a house a year ago and got a $250,000 mortgage with a 5-year fixed term at 6% interest. With a 25-year amortization, the payments were $1599.52 per month. After 5 years, the remaining mortgage balance would be $224,592.

Sue’s job is moving to another city and the Wards have now sold their house. Their latest statement says that the remaining mortgage balance is $245,501. However, this figure has no connection to the Wards’ actual obligations.

When they signed for their mortgage a year ago, the Wards agreed to make 60 monthly payments of $1599.52 and a lump sum of $224,592 after 5 years. A year into the mortgage, their obligation is 48 more monthly payments plus this lump sum.

The remaining balance shown on their mortgage statement assumes that interest rates have remained the same. But, what if rates have dropped? Suppose that the current rate for a 4-year term is down to 4%. This means that their supposed mortgage balance is a meaningless number. What the Wards really owe is 4 years of monthly payments of $1599.52 plus the lump sum.

To figure out what the Ward’s really owe, we need to find the mortgage balance that would give a monthly payment of $1599.52 and a lump sum after 4 years of $245,501 based on 4% interest. Their debt turns out to be $262,574! This is $17,073 more than the amount on their mortgage statement.

Such a large interest rate differential penalty can come as quite a shock. The Wards didn’t realize it, but when they signed for their mortgage, they were betting against an interest rate drop and lost this bet.

There are a number of potential complications when calculating an actual interest rate differential (IRD). Prepayment privileges, like doubled payments or yearly lump-sums, should lower the IRD. There are various ways of estimating the IRD, and most of these overstate a fair amount.

For example, one might say that the bank will be missing out on 2% interest for 4 years on an average balance of about $235,000. This works out to a penalty of $18,800. This is $1727 too much. The problem with this estimate is that it takes future amounts of bank losses and doesn’t discount them before collecting them in the present.

I was unable to find a description of how various banks actually calculate IRDs, although several web sites give ways to estimate the amount. The fair method that I used in the example is simple enough, and there is no excuse for using an inflated “estimate”. However, banks would rather have more money than less.

7 comments:

  1. I must say, this one lost me a bit, but my eyes glazed over when you said "fixed-rate mortgage" since I don't plan to ever get one of those. Does this IRD apply to variable-rate mortgages?

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  2. Patrick: As far as I'm aware, an IRD would not apply to variable-rate mortgages, but I recommend reading any mortgage contract before signing it.

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  3. I didn't realize this there was such a thing as an Interest Rate Differential, but it makes sense. It also puts mortgage break fees into perspective for me.

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  4. My wife and I just got hit with $18k Interest Rate Differential mortgage fees when we cancelled our 3-year closed mortgage with 26 months to go.

    This fee was never explained to us when we sat down an signed the paperwork, if we'd have known we'd have NEVER signed.

    What bothers me is our initial interest rate was 7.99% (obviously not for primo clients), but we're being charged the best rate now - 4.05% - on the cancellation. Why is that!?!? Shouldn't it be what we would be able to secure now?

    Apples to apples, oranges to oranges.

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  5. Rory: It is likely that the bank's actions can be justified by the language in your mortgage agreement, but that won't make the big penalty any easier to take. If people had these penalties properly explained to them, some customers who know they might have to sell their homes early might not opt for a long lock-in on their mortgages. As for the apples to oranges comparison, I suspect the bank would justify it by saying that they have already taken on default risk for giving you a mortgage in the first place and they deserve to be compensated for that risk. I don't fully buy this argument myself, but that is likely how the bank would present its case.

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  6. So here is one for you.

    Mortgage balance: 138,000 - 42 months left.
    Current rate on my 5 yr closed is 3.9%
    Banks says on Discharge Statement that they will re-invest at 4.10% interest rate yet want to charge me $5115 in penalty.!

    I think I'm getting hosed here.!!

    Main reason is that 10 days ago and I have e-mail to prove it, was quoted 1790 in penalty + 225 for admin fees...What say you.?? I think it should only be (in Canada), the 3 months interest. Which when the nunmbers come down is even less than quoted amount..About 1350.

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  7. @Theo: I'm trying to understand the figures you stated. What do you mean by "reinvest at 4.10%"? Are you selling your house? Based on the figures you mention the best plan is to stick with your current mortgage.

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