What happens when a Fixed rate mortgage is paid out before the term ends?
When a Borrower pays out their mortgage during the term, the Lender no longer receives interest on the mortgage, however the expenses related to the mortgage (the “Lender’s Cost”) still exist. If the interest rate available to re-lend funds for the remaining term of the mortgage is less than the Mortgage Interest Rate, there may be an IRD penalty due.
Prepayment penalties occur when a borrower pays more towards principal than what is allowed under the prepayment privileges of their mortgage contract.
If a borrower pays down their mortgage beyond the prepayment privilege, the lender is owed compensation (penalty) by the borrower. In some circumstances that compensation is an Interest Rate Differential (IRD).
IRD is a formula typically composed of three components
1. The difference between two interest rates (“Re-Lending Rate Variance”); typically, the Mortgage Interest Rate and the interest rate that is available for the remaining term, and:
2. The balance that is subject to the penalty, and:
3. The time to maturity
A simplified expression of the IRD is:
IRD = Principal Amount (A) x Re-Lending Rate Variance (B) x Time to maturity (C)
Since the principal amount (A) is paid down over time and the time to maturity (C) is also reducing as time passes during the term, these two elements have a reducing impact on the IRD.
When the IRD increases from one day to the next it is because the “Re-Lending Rate Variance” has increased. Increases in the Re- Lending Rate Variance are caused by the rate available to re-lend the funds for the remaining term having been reduced. This is a result of either:
1. A reduction in the current interest rate for the remaining term, or
2. The ‘remaining term’ used in the calculation having changed to a term with a lower interest rate because of the passage of time (was using the 3-year rate and now using the 2-year rate with a lower rate).
A small change in the current interest rate can have a large impact on the Re-Lending Rate Variance, and thus a large impact on the IRD penalty.
Simply put, if interest rates go up, your penalty will be smaller, if they go down your penalty will larger