If you’ve tried to early renew or refinance your mortgage in the last few years you’ve probably been told by your bank that you have a substantial penalty to pay if you are locked into a fixed rate mortgage. You probably questioned it as it didn’t seem like current rates were much lower than yours; however, the friendly employee at your local bank wasn’t really able or willing to explain why it was so high. In this article, we give you some information on how the banks have managed to manipulate penalties so they are higher than they should be and what options you have to counteract this. We also show you the formula used for mortgage penalty calculations.
First of all, on fixed rate mortgages, all lenders usually charge you one of two penalties. It is the greater of 3 months interest or the interest rate differential. 3 months of interest is usually a pretty small penalty (less than 3 months of payments). The interest rate differential is a whole other calculation and is determined as follows.
Let’s assume you have a 5 year fixed rate right now of 3.80% that you got 3 years ago. This would be a discounted rate off of the posted rate. Your posted rate may have been around 5.3% when you got the mortgage. Now let’s assume you want to pay out the mortgage with 2 years left in your term. To calculate the penalty the bank will need to determine what the posted rate is on a 2 year mortgage. Let’s say for example this 2 year posted rate is 3.50%. If you have a $300,000 mortgage here is how the penalty is calculated:
|Posted rate on your mortgage:||5.3%|
|Less Posted rate for time left:||3.5%|
|Multiplied by your balance:||$300,000|
|Multiplied by years remaining:||2|
This is a very real scenario and based on current rates you would have to pay this $10,800 penalty just to get into a new 5 year fixed rate of around 3.19% right now. So what have the banks done in the last several years to ensure their penalties remain high even though customers are getting out of one set of low rates only to get into another set of very similar low rates? You would think that if your rate was in the 4 – 5% range that your penalty would be high as you are trying to break out of that contract for a much lower rate. However you wouldn’t think that by going from 3.8% to 3.19% that the penalty would be so high. Well here is what the banks have done.
Over the last several years banks have artificially left the posted rate on their 5 year term high. In the past there was usually a 1.2% – 1.3% discount off of the posted rate to give you the best 5 year discounted rate. Based on that premise this means todays 5 year posted rate would be around 4.4%. However, for most banks it has been over 5%. Rather than lowering the posted rate they have just increased the discount. So what is this significance of this? The higher the posted rate on your mortgage, the bigger the difference the bank will create when it calculates the above penalty.
The other big thing they do is to leave the posted rates on the shorter terms (1 – 3 year) quite low. They don’t offer big discounts on the shorter terms. They simply leave the posted rate low and give you a smaller discount. This also creates a bigger spread when they take the posted rate on your 5 year term and minus the posted rate for the time left. It is a very clever manipulation that most people don’t consider.
Most people take 5 year terms so they keep the posted rate on this term really high. Then they keep the posted rates on the shorter terms really low. This creates a very large spread between the two sets of rates and dramatically increases your penalty even though often you are not decreasing you ACTUAL RATE by that large of a spread. The average person tries to get out of their mortgage within the first 4 years so the banks know they have your in their claws!
The banks can do this because they control their posted rates and most mortgage consumers have no clue and don’t consider this when getting a mortgage. We have a couple of alternatives for you that may help you to minimize the impact of this manipulation.
First of all, consider a variable rate mortgage. These types of mortgages fluctuate with prime rate so they do carry a bigger risk than fixed rate mortgages. However, they only carry a 3 month interest penalty which is usually very bearable.
The second option is to ask us about the non-bank lenders we use. We have access to many lenders that don’t have branches like the banks. They offer great online & phone service but just don’t have bricks and mortar structures like the banks. In most cases their rates are better and all of the terms & conditions of their mortgages are usually the same as the banks. They are federally regulated lenders and are often under tighter scrutiny than the banks. So why would we mention these lenders versus your traditional banks and credit unions?
Many of these non-bank lenders don’t have your traditional “posted rates” like the banks do. Their rates are their rates. This means that when you get a 5 year fixed rate right now at let’s say 3.09% then that is their posted rate & their discounted rate. There is no difference. This makes a huge difference in penalty calculations by virtually eliminating most of the spread in the calculation we showed you above. So rather than having a penalty in the tens of thousands of dollars your penalty might only be a couple of thousand.
Many customers end up trying to get out of their mortgage before their term is up. Dealing with a non-bank lender can help severely lessen the impact of high penalties that the banks will most definitely charge you.