To put it bluntly, the Interest Rate Differential Amount is often a shocker for borrowers looking to prepay their mortgage. When borrowing money on a mortgage, the borrower is entering into a contract with the lender to pay the lender interest at a set rate for a set term. Lenders protect themselves by charging a prepayment penalty to a borrower that wants to break the mortgage contract. This amount is the amount a lender will lose over the remaining term on a closed mortgage by receiving the mortgage funds back, and having to lend out to a new borrower at a lower rate of interest.
Let’s use an example to show how this penalty amount could be crippling for a borrower. Borrower contracts to borrow $400,000.00 at 3.75% for a 5 year term – a mortgage quite common for a standard house in Kelowna. Borrower sells with 3 years remaining on the term, with no plans to purchase a new house. By returning the $400,000.00 (less some principal paid over the initial 3 years) to a lender when there is 3 years left on a five year term, the lender will then loan the funds out to a new borrower at its posted rate at the time the funds are repaid, say 3% for this example. The lender then loses 0.75% on $400,000.00 over the following 3 years, and charges Borrower a prepayment penalty equal to the amount it is losing by Borrower repaying the funds early. A simple calculation (often the calculation is not simple) would suggest that 0.75% on $400,000.00 per year results in $3750 per year payable…then multiply that by the balance of years left in the term – in this example 3 – resulting in prepayment penalty of over $11,000. This could come as quite a shock to Borrower who expected to pay three months interest, which may be a couple thousand dollars at most.
There is good news though. The IRD amount will only apply when the posted rate at the time the funds are borrowed is higher than the posted rate when the funds are repaid. This means that when rates start rising and the posted rate at the time the funds are borrowed is less than the posted rate when the funds are returned, the lender is happy to have the mortgage funds back so that it can lend it out at a higher rate and make more funds off the new borrower. So, always compare these rates when considering prepaying your mortgage in full so that you are not caught by the nasty IRD prepayment penalty.