What is an Interest Rate Differential?
An interest rate differential (IRD) is the difference between the interest rate on your mortgage contract and the interest rate the lender is currently offering on mortgages.
The IRD is primarily used to calculate the penalty a lender charges a homeowner if they break their mortgage before their mortgage term ends.
The IRD calculation only applies to closed fixed-rate mortgages.
These mortgages allow you to lock in a fixed interest rate for the duration of the mortgage term.
They also prohibit you from contributing additional payments on top of your regular mortgage payment schedule.
Banks include a ‘break penalty’ in mortgage contracts to dissuade borrowers from paying off their mortgage early or refinancing it.
Since the primary source of revenue for banks comes from interest collected on loans issued, it’s not in their best interest to have homeowners paying off mortgages ahead of schedule.
The longer a mortgage remains outstanding, the longer interest revenue is collected.
Should a homeowner decide to break their mortgage, the break penalty helps offset the lost interest revenue.
3 Month Interest Penalty vs Interest Rate Differential Penalty
The standard break penalty for mortgages in Canada is the higher of the IRD or three months’ interest.
The primary difference between the two penalty types is how the lender determines the amount you must pay.
To calculate the IRD, lenders obtain the difference between the rate on your mortgage contract and the rate they are currently assigning to new mortgages they issue.
They then multiply the difference between the two rates by your existing mortgage principal and divide by 12 months to figure out the monthly fee.
They then multiply this fee by the number of months remaining in your mortgage term, which works out to the IRD you’re obligated to pay.
The 3-month-interest penalty is more straightforward to figure out.
It consists of charges equivalent to three months worth of interest on your existing mortgage.
Keep in mind that the above calculations are a general rule.
Each lender has a unique policy that outlines how the IRD is to be determined.
The Big Five banks, for example, tend to be more punitive when it comes to the IRD than non-bank lenders.
Your specific mortgage product, remaining term length, and prepayment size are also crucial factors that can affect the IRD calculation.
In 2013, the Financial Consumer Agency of Canada called on all federally regulated lending institutions to provide penalty calculators on their websites. Most complied, helping to bolster transparency about how mortgage penalties are assessed.
Calculating a 3-Month Interest Penalty
Here’s how to determine your 3-month interest penalty:
First, determine your remaining mortgage principal and interest rate initially assigned to you (or your current rate if you have a variable-rate mortgage).
Let’s assume your principal is $350,000 and your interest rate is 4.25%.
Next, calculate how much interest you would pay in one month.
Using our example, your monthly interest charge would be $1239.59 ($350,000 x 4.25% / 12 months).
Finally, multiply the monthly interest amount by three to determine your 3-month penalty interest rate.
In this case, it would be $3,718.77.
Calculating an Interest Rate Differential (IRD) Penalty
Here’s how to determine your IRD (we’ll use the previous mortgage principal amount and interest rate):
First, calculate how many months you have remaining in your mortgage term and round up to the nearest year.
Continuing with our example, if your product is a five-year fixed-rate mortgage with 33 months left, you’ll use three years as an approximate measure.
Next, estimate your lender’s current rate offering for a similar mortgage of the same length, so a term of three years.
Let’s assume the current rate on three year mortgages from your lender is 3% – subtract that from your current rate of 4.25%.
The difference, in this case, would be 1.25%.
Next, multiply the difference of the two rates by your remaining principal and divide by 12 months.
In our example, you would get a $364.58 ($350,000 x 1.25% / 12 months) monthly penalty.
Finally, multiple the monthly penalty by the number of months left in your mortgage term to assess the IRD.
In this case, the IRD is $12,031.14 ($364.58 x 33 months).
To close out, most mortgage contracts require that you pay the higher of the two, so in this case your break penalty would be around $12,000!
How do Rising Mortgage Rates Affect the IRD?
While the IRD can be pretty steep, the good news is that it applies to lenders’ penalty calculations only when your contracted mortgage rate is higher than their current posted rate.
Continuing with our example, let’s assume your contracted rate is 4.25%, but your lender’s current mortgage rate offering for a three-year mortgage is 5%.
Should you break your mortgage in this scenario, the lender would assess your penalty as three months’ interest, as the IRD calculation would result in a negative figure.
As a result, you’d end up paying $3,718.77 rather than $12,000.
The lower penalty shouldn’t come as a surprise, as your lender is happy to terminate your mortgage and lend out the funds at the higher rate that the market is accepting.
Generally, breaking a fixed-rate mortgage in an environment where interest rates are rising is more cost-effective than in one where rates are falling.
And while ending a mortgage contract early to obtain a new one at a higher interest rate doesn’t make sense financially, it may be the optimal decision based on your circumstances.
For example, if your family situation has changed or you’ve secured a new job in another city, you may have no choice but to sell your current home.
In such scenarios, you’ll likely pay a higher rate for your new mortgage since rates are rising.
However, there’s a good chance the IRD on your existing mortgage will be very low or even negative. As a result, your lender will assess your penalty as three months’ interest, which is usually a much cheaper alternative than the IRD.
Did You Know!
Lenders set the penalty on a closed variable-rate mortgage as three months’ interest – they don’t use the interest rate differential, which applies to fixed-rate mortgages.
Frequently Asked Questions
- What is the penalty to break a mortgage?
If your mortgage is variable-rate, your penalty is the equivalent of three months’ interest. If your mortgage is fixed, your penalty is typically the greater of the IRD or three months’ interest.
- How is the mortgage interest differential calculated?
In general, a lender will utilize two interest rates: the rate set in your mortgage contract and the rate they extend to current borrowers. They multiply the difference between the two rates by your remaining principal and divide the resulting figure by 12 months. They then take this figure and multiply it by the number of months left on your mortgage term, which results in the IRD penalty amount.