How do lenders calculate Mortgage Penalities (hypotheque)

How do banks calculate mortgage penalties?

(Note: This article is part of a series on the topic of mortgage penalties. Your own mortgage penalty question may be more directly answered in one of the other articles. Please see the list of articles at the end of this one.)

There are two ways that mortgage lenders figure mortgage penalties. Needless to say, since there are two ways, they will choose the one that is most advantageous for them.

1. Number of months interest penalty (2, 3 or 6 months). You have to separate the interest piece of your mortgage payment from the principal and then multiply it by the number of months designated for the penalty.

Example: If a borrower pays his mortgage after thirty months, for a 25 year mortgage of $200,000 at 5.4%, his monthly disbursements will be $1,209.17 and the interest on the 30th payment will be $846.18. So, if the penalty is 3 months, the cost of the penalty in this example will be 3 X $846.18 or $2,538.55.

2. Rate differential calculation. This is really the difference between the rates for the balance of the loan. This is more complicated to calculate, but the rationale of it is easy to see. This calculation is used when the rate in force at the time you break your loan contract is lower than the rate on your loan when negotiated. The penalty is calculated as the difference between the mortgage interest rate on the old loan and the amount the bank will make on a new loan at this time. Here is an example to see it better:

Example: Let us take the same scenario; you have a $200,000 mortgage amortized over 25 years with a rate of 5.4% for 5 years and a payment of $1,209.17 per month. After 30 months, you have to break your home loan contract (pre-payment) and the lender will charge you a penalty. The rate at that moment (30 months later) is 4.75%.

Here is how it is calculated:

a. The lender should have received a certain amount on this loan based on the original rate of 5.4%. Using a financial calculator, the lender determines this amount to be $25, 447.16, which represents the payments from the 30th month through the 60th month, or five years.

b.The amount of interest that that lender can receive now if it lent the money at the rate of 4.75% for the 31 month period (30th payment through 60th payment) is calculated, again using a financial calculator, at $22,250.74.

c. The final step is to calculate the difference between what the lender should have earned and what he will earn at the new lower rate. No financial calculator needed for this: $25,447.16 minus $22,250.74 equals $3,196.26, and you have the penalty!

Borrowers have a hard time understanding this system.

No borrower wants to pay a penalty on his mortgage! That’s for sure, but all mortgage loans, apart from some unusual types of open mortgages, have penalties for prepayments. The subject of penalties includes many aspects which need clear explanation and examples in order to be able to fully understand them.

Gregory is an Accredited Mortgage Professional (AMP). To get more information on mortgage rates - taux hypothécaire, please visit: Hypothèque - Get a loan