Thursday, November 24, 2011

Gaming Mortgage-Breaking Costs

Trying to break a mortgage before your term is up can be a bewildering experience. If interest rates have gone down since you took a fixed term, the bank will ask for an "interest rate differential" (IRD), which is a mortgage-breaking fee. Few people understand how this IRD is calculated and the banks don't make it easy to find out. There is an interesting way for banks to game the IRD calculations as I'll explain, but I have no idea if any of them actually do it.

Most people know that a bank's posted mortgage rates are just a starting point for negotiations; borrowers usually qualify for a discounted rate depending on their credit record. The size of these discounts is controlled by the bank. A bank could raise its posted rate by a half-point and then give larger discounts without affecting the rates on the mortgages they write. By playing with posted rates and the size of this discount, I’ll show how a bank could affect the size of IRD penalties.

The basic principle behind an IRD is that you have to honour your obligation. If you promise to pay 6% interest for 5 years and rates go down after 2 years, you can't just get a mortgage at a lower rate without paying the bank an IRD to compensate them for not getting the larger payments for 3 more years. The bank can't renege on its promised rate for the term you choose and you can't either.

Continuing with this example, suppose that right now you would qualify for a 4% mortgage for a 3-year fixed term. Then the bank takes your future 3 years of payments and the lump sum that would be owing at the end of the 3 years, finds their present value (at 4%), and calls the difference between this amount and your outstanding mortgage balance the IRD. So, when you pay the IRD plus your outstanding mortgage balance, you are effectively paying the present value of the future obligations of your existing mortgage (at 4%).

An important wrinkle here is how the bank came up with your initial rate of 6% and how they chose the 4% rate for the IRD calculation. Suppose that the posted rate for your initial 5-year term was 8%. Then you got a 2% discount. Some banks reason that to choose the rate for the IRD calculation, they should take 2% off the current posted 3-year rate. (Keep in mind that the lower the rate used for IRD, the larger the IRD fee will be.)

This approach has potential problems. Perhaps discounts on shorter terms tend to be smaller than those on longer-term mortgages. If this were true, then the IRD rate would be artificially low making the IRD fee unfairly high.

Another potential problem is that the banks control the amount of mortgage rate discounts. Competitive pressures limit the ability of banks to control the rates at which they write mortgages, but they do control their posted rates. This means that they control the typical rate discount.

So, suppose that the typical discount is 2% during a period of higher interest rates and then rates drop. This creates conditions where homeowners will want to break their mortgages. If the bank then changes their advertised rates to be only 0.5% higher than the typical mortgage they write, then when someone breaks a mortgage, the IRD rate used will be 2% less than the posted rate, which is 1.5% lower than the actual rate the homeowner could get. This artificially increases the IRD significantly.

I have no idea if banks actually do this, but it would surely be tempting. To check whether this sort of thing goes on, I'd need some information that I don't currently have:

- What is the exact method each bank uses for IRD calculation?
- How do they arrive at the rate to compute the IRD?
- How does the typical mortgage rate discount vary with length of term?
- How has the typical mortgage rate discount varied with interest rate levels?

TD has some online IRD information, but of the 4 questions above, the only one that is answered is how they compute the IRD interest rate. They give a calculator for estimating your IRD, but not an exact calculation. Royal Bank has some IRD information as well, but it isn’t any more helpful than the TD link. BMO has similar IRD information, CIBC’s is no better, and neither is Scotiabank’s.

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