When it comes to finalizing a mortgage, both the lender and the borrower sign on under the expectation that the length of the agreed term will be lived out. Not only does this give the borrower a lengthy amount of time to pay off their loan, it also gives the lender a steady line of profit from interest on each payment. However, when a homeowner decides to sell their home, whether they start a new mortgage agreement or not, lenders will charge a penalty for the breach in contract, known as the IRD (also known as the Interest Rate Differential). Let’s explore exactly what IRD is and why it’s incorporated into your mortgage agreement.
What is IRD?
Once you’ve signed your mortgage agreement, your payments and interest rate are set. However, there can be circumstances which cause you to break this agreement and leave before the previously decided end time. A common situation causing you to break your agreement that we see is when you’ve sold your home in an effort to consolidate two homes into one, where you aren’t purchasing another home. Because you aren’t buying another home that you could port the existing mortgage to you’re at risk of getting slapped with the cost of paying the Interest Rate Differential, or IRD. Another common culprit for breaking your mortgage agreement which can result in a penalty is if you refinance your mortgage with another lender, for example in divorce or perhaps if you’ve reverted from being a home owner, back to renting a property opposed to owning one.
At first thought, it seems strange to punish borrowers for paying back their mortgage loan with the sale of their home before the expected end. However, when you break your mortgage agreement, your lender will be missing out on the expected profit from your interest over the 10, 15 or even 20 years remaining. Due to this loss, mortgage lenders implemented a penalty for breaking the agreement early to cover the lost revenue.
How Is It Calculated?
Generally, the penalty is the higher cost of two calculations: three months’ interest or a formula known as the Interest Rate Differential (IRD). If a homeowner breaks their variable rate mortgage, the penalty cost will be the equivalent of three months of interest. However, if you’re on a fixed rate mortgage, the IRD is used, which differs in calculation from lender to lender, but is usually based on the remaining time left in your agreement.
Essentially, your IRD is based on the amount you are pre-paying and the interest rate that equals the difference between your original interest rate and the interest rate a lender can charge today. Confusing, we know.
The problem is, the difference in penalty costs between a variable rate and fixed rate mortgage can be massive. Let’s say your current mortgage balance is $200,000 with an interest rate of 5% with 24 months remaining on your term. With a variable rate mortgage, you’d only have to pay a 3-month penalty equaling about $2,500. However, if you’re on a fixed rate mortgage, you can be paying up to $11,000 in penalties.
When it comes to getting out of your mortgage agreement, it’s no surprise that there will be penalties, much like breaking any contract. However, even though lenders understand that mortgage contracts being paid back before their last month of term happens and circumstances arise that require the sale of homes and termination of agreements, they are operating a business which keeps profit in the front of their priorities. Navigating the transaction without a huge hit to your wallet can be difficult. If you have any questions about ending your mortgage agreement and the financial penalties you may be faced with, don’t hesitate to give me a call at 705-315-0516. I am always happy to help you better understand your financial obligations and get you into a position of financial stability with your mortgage whether existing or with a new mortgage for a home you’re about to purchase.