Take out a mortgage? Avoid tying it to the rate posted by the big banks

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My wife and I recently considered selling a small condo that we bought in Montreal eight years ago. The four-year fixed mortgage we have on the asset is approximately $ 200,000, with an annual interest rate of 3.24%.

In retrospect, going for a variable rate would have been a much better choice, but at the time, getting a rate of 3.24% seemed attractive enough.

We knew that paying off the mortgage in full – a year and a half before it was renewed – would incur penalties, but when I asked the Bank of Montreal what the exact amount would be, I was amazed to learn that the penalties would amount to $ 6,717.

You read that right, a penalty of almost $ 7,000 for breaking a small mortgage of $ 200,000 just 21 months before maturity.

How could it be? I asked. What I had in mind was a general rule that the penalty for early termination of a mortgage is equal to three months of interest. In our case, it would have cost us about $ 1,700 in fees. But $ 7,000?

I took a closer look at my mortgage statement and realized I was caught off guard when I renewed it a few years ago.

Our rate was effectively locked in for four years at 3.24%, but it was defined as BMO’s “posted rate” at the time we took out the mortgage – 4.89% – minus a “rate discount” of 1. , 65%.

In a case like ours, as long as the mortgage matures in accordance with the plan, no special penalty will apply. But if paid early, that “discount” we received on the posted rate could actually turn out to be quite expensive.

By applying the “interest rate differential” (IRD) – a somewhat complicated calculation that few borrowers fully understand – the big banks are imposing massive penalties of up to five percent of the loan value (or of the principal).

To be fair, banks should receive some compensation when a customer pays off a mortgage in full before maturity. When a bank initiates a mortgage loan, for example by offering a five-year fixed rate loan, it usually hedges (eliminates) its interest rate risk by placing itself in an opposite position to the one it provided to the bank. customer.

If the mortgage is paid in full prematurely, say after three years, the bank will have to cover its covered position that it held against the mortgage. If interest rates change, it could expose the bank to a loss, and the penalties compensate the bank for that loss.

But the way Canadian banks calculate these penalties results in excessive and unfair fees.

In Canada, the big six banks have several mortgage rate menus. First, there are the so-called “posted rates”. These rates are usually inflated and should be viewed as a sticker price for a new vehicle, a rate no one should ever pay.

Currently, the rate posted by the Big Six banks for a five-year fixed rate mortgage is 4.79 percent. The rate is considerably higher than the yield on five-year Government of Canada bonds, which stands at 0.87%, a good approximation of the cost to the bank of financing the mortgages it offers.

Then there are the “special rates” or “best available rates” from the big banks which are the competitive rates you should aim to lock in. The special five-year fixed rate for the Big Six is ​​currently around 2.44 percent. This means that banks are ready to initiate five-year fixed rate mortgages at 235 basis points below their posted rates, making you wonder why are the posted rates so high?

If you do your research and negotiate, the big banks will offer you a competitive rate, well below their posted rate. But almost always, they will always tie your reduced rate to the posted rate in a way that will result in higher fees if the mortgage breaks early.

Robert McLister is Mortgage Expert and Editor at RATESDOTCA. He has studied the Canadian mortgage market for years. “If you ask me if you can get a five-year fixed mortgage from a big bank without any chance of paying high penalties, the answer is definitely no,” he told me during a telephone interview.

There’s a good reason the five-year fixed rate – by far the most popular among Canadians – is so overkill. The IRD, the formula that generates high penalties for banks, is all the greater as the difference between the rate posted at the time a mortgage was initiated and the bank’s posted rate with the remaining term (for example , two years fixed) when the mortgage is prepaid.

Since the majority of mortgages in Canada start with a five-year fixed rate, it is beneficial for banks to keep the posted five-year rate artificially high.

Mortgage Professionals Canada, the country’s mortgage industry association representing more than 13,000 individuals and over 1,000 businesses, confirms this observation.

In its recent publication, Annual State of the Residential Housing Market in Canada 2020, the association highlights the huge gap between the average mortgage rate posted over five years (4.95%) and the average mortgage interest rate (2, 25%) and concludes: “This confirms that, more and more, the rates posted by banks are not set with reference to the real market.

Therefore, according to mortgage professionals in Canada, the rate posted by the big banks is essentially a ploy.

Lack of competition is one of the reasons this is possible, according to McLister. “In Canada, we have six major banks that directly or indirectly control over four in five mortgage dollars through financing and direct origination. Most countries do not have this level of concentration in the banking system, ”he explains.

So what should you do the next time you need a mortgage?

The best way to avoid paying high prepayment penalties is to choose an adjustable rate mortgage. Then, in most cases, the banks would only charge you three months of interest for the early termination of a mortgage, which is fair.

But in today’s low interest rate environment, many are rightly tempted to lock in a five-year fixed rate. In this case, choose a lender that has only one set of discount rates. Tangerine (owned by Scotia) is a good example. This way, even if you break your mortgage sooner, the penalties will be much more reasonable.

Amir Barnea is an associate professor of finance at HEC Montreal and a freelance columnist at Star. Follow him on Twitter: @ abarnea1



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