Mortgage Payout Penalties – Meaning and Calculation

There are a number of topics important topics in the Mortgage Courses that you should know and understand in order to become a Mortgage Broker or Mortgage Associate in Alberta. Mortgage Payout Penalties is one of them. There is a good chance that you see this topic in the Mortgage Exam. So, let’s understand the topic in detail.

What are Mortgage Payout Penalties?

Mortgage Payout Penalty, also known as Mortgage Pre-Payment Penalty, is a fee that a mortgage lender may charge the borrower if the borrower:

1. Breaks the Mortgage Contract
2. Transfers the mortgage to another lender before the end of the mortgage term
3. Pays back the entire mortgage before the end of the mortgage term. Here, selling the house is also considered as the same option.

In case of any of the above scenarios, the lender will lose their buyer and the potential future income they could generate from their mortgage, which is a loss for them. Thus, they charge legal penalties to the buyer to demotivate them from doing any of the above. The conditions as to when and how much the penalties will be applied is included in the mortgage contract offered by the lender.

Types of Mortgage Payout Penalties

There are two types of Mortgage Payout Penalties:

1. 3-Month Interest Penalty
2. Interest Rate Differential (IRD) Penalty

3-Month Interest Penalty

Meaning

In this type of penalty, the lender will charge the 3 months worth of interest rate to the buyer as a penalty for breaking term of the mortgage. This type of penalty is usually applied in variable rate mortgage.

Here, the current interest rate in the market is considered to charge the penalty.

Formula

How to Calculate 3-month Interest Penalty in a Mortgage with Example

Question: John Smith is interested in re-financing his house as the mortgage rates have dropped. He has $200,000 remaining on his mortgage. He is 2 years into a 5-year variable term mortgage. When he purchased his property, the interest rate was 5.50%. Today’s 3-year interest rate is 3.5.%. As per his mortgage contract, the lender will charge him 3-year interest rate or interest rate differential as penalty, whichever is higher. How much payout penalty will John have to pay to break his mortgage contract?

Solution:

Important Variables in the Scenario:

1. Mortgage Balance: $200,000.00
2. Previous Interest Rate: 5.50% (or 0.055)
3. Current Interest Rate: 3.50% (or 0.035)

Formula for 3-month Interest Rate Penalty Calculation:

((Mortgage Balance x Annual Interest Rate) / 12 months) x 3 months

Calculation:

Interest Rate for entire year: $200,000 x 0.055 = $11,000

Interest Rate for one month: $11,000/12 = $916.67

Interest Rate for 3 months: $916.67 x 3 months = $2,750

Interest Rate Differential (IRD) Penalty

Meaning

As opposed to the 3-month interest penalty where the current rate is levied for penalty, the interest rate differential, the difference between the interest rate at the start of the mortgage and the current interest rate is calculated. The mortgage calculated from the differential interest rate and the mortgage amount with the current interest rate on the remaining mortgage balance is compared and the higher is inferred as penalty. This penalty is usually practiced with fixed rate mortgages.

Formula

How to Calculate IRD Penalty in a Mortgage with Example

Question: John Smith is interested in re-financing his house as the mortgage rates have dropped. He has $200,000 remaining on his mortgage. He is 2 years into a 5-year fixed term mortgage. When he purchased his property, the interest rate was 5.50%. Today’s 3-year interest rate is 3.5.%. As per his mortgage contract, the lender will charge him 3-year interest rate or interest rate differential as penalty, whichever is higher. How much payout penalty will John have to pay to break his mortgage contract?

Solution:

Important Variables in the Scenario:

1. Mortgage Balance: $200,000.00
2. Previous Interest Rate: 5.50% (or 0.055)
3. Current Interest Rate: 3.50% (or 0.035)

1^St – Formula for 3-month Interest Rate Penalty Calculation:

((Mortgage Balance x Annual Interest Rate) / 12 months) x 3 months

Calculation:

Interest Rate for entire year: $200,000 x 0.055 = $11,000

Interest Rate for one month: $11,000/12 = $916.67

Interest Rate for 3 months: $916.67 x 3 months = $2,750

2^nd – Formula for IRD Penalty Calculation:

(Mortgage Balance x Annual Interest Rate Differential) x Remaining Term in Months

Calculation:

Annual Interest Rate Differential: 5.5% – 3.5% = 2% or 0.02

Interest For Outstanding Balance of Mortgage for 1 year: $200,000 x 0.02 = $4,000

Interest for Outstanding Balance for 1 month: $4,000/12 = $333.33
[Optional Step (do it only if you want to convert the amount in months, in case the remaining term has a decimal number for years like 1.2 years)]

Interest for Remaining Term (in months): $333.33 x 3 years (36 months) = $12,000

$12,000 > $2,750

Thus, the lender would apply the IRD Payout Penalty ($12,000) as it is higher of the two amounts.

Hope you enjoyed the blog and understood the concept of Payout Penalties in Mortgage Brokerage. Join Alberta Real Estate School for expert help with learning Real Estate & Mortgage Brokerage Courses.

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