Have you read carefully your mortgage contract? Or, being in the euphoria of purchasing your home, you relied on the bank clerk to explain only the important things to you and show where the dotted line is? If you haven’t read it; take the time to do it and you will be amazed how well protected is your lender.
It starts with small things like
- $200 charge for a NSF (when for some reason your regular payment did not go through);
- $50 charge for a missed payment;
- $250 charge for legal demand (when the bank has to use legal means to demand a payment);
… and continues with penalties if you breach the contract of the mortgage.
While some charges are reasonable and needed to motivate borrowers to pay their mortgage on time, that’s not the case with the penalties.
Banks and other lenders would charge stiff penalties any time a borrower tries to switch their mortgage before the end of the term to another lender, or pay it in full.
Example I. You have signed on a mortgage for five years at 5.25% fixed interest rate. After two years you realize that other banks offer mortgages at rates at 4.0%. You want to switch to a lender with better rate. Fine, but the bank will charge you pre-payment penalty fees.
Example 2. There is one more year before the end of the term on your mortgage, however, you have to sell the home and relocate to another province. When you pay the mortgage in full, the bank will charge pre-payment penalty fees.
Pre-payment penalty charges are well stipulated in your mortgage document. The amount depends on many factors, however, for fixed rate mortgages they are always calculated using the IRD method (Interest Rate Differential – we will discuss the method in more details in another article) and usually come to thousands of dollars. If there was any advantage to switch to lower rate, after paying the penalties, the benefits become questionable.
Pre-payment penalties are designed to recapture the interest earned by the bank if you were to stay till the end of the term. They keep the borrower chained to the financial institution. They discourage shopping for better terms elsewhere. In another words, they favour the bank, not the consumer.
Banks take minimal risk with your mortgage, because:
- The mortgage amount may be insured by CMHC against your default (and you pay the premium!)
- The title is protected by a Title Insurance (and you pay the premium)
- And the profit is protected by imposing the penalties for pre-payment (and you pay the penalties).
Well, that’s not fair, isn’t it?
So, what can we do about it? Perhaps we can try to convince the Canadian government to follow the example of Australia and ban the pre-payment fees all together. No, I am not crazy. Australian regulators found that such fees are so unfair that they have to be banned.
Today Australia passed a law banning the so called “exit fees”. Here is what International Business Times reports:
Treasurer Wayne Swan (of Australia) said the passage of this law is a victory for Australian families “This is an important day for consumers because one of the biggest roadblocks stopping Australians getting a better deal for their families will finally be removed,” he said…“This critical measure will help boost competition in the home loan market over time, by giving consumers greater freedom to walk down the road if their bank isn’t doing the right thing by them.”
Exit fees can be so high that they completely wipe out the savings from switching to a cheaper mortgage with another lender.
“Exit fees” in Australia are the equivalent of our pre-payment penalty fees. Here is the explanation of “exit fees”:
Exit fees, or early redemption penalties, are fees that are charged to a home owner when they are finishing their loan at an earlier stage of the loan than agreed… Exit fees are often a hidden cost when changing mortgages. A mortgage can look to be a lot cheaper, but the exit fees from the old mortgage will often mean that the cost is quite a bit higher than it appeared at first.
Australians are very lucky. As of June 1st this year, exit fees are banned in Australia. Canadians will continue to pay thousands of dollars for the pleasure of accepting a better offer from competitors. If pre-payment fees are reduced or eliminated, the banks will actually take some risk and you the borrower will have a real choice.
Are we that different than the Australians?