Interest Rate Differential (IRD)

There are plenty of reasons it might make sense to break your mortgage early, but the main deterrent from doing so is mortgage penalty fees. There are two main ways that lenders calculate mortgage penalties. The more common of the two is simple: 3 months of interest on the current principal of your mortgage.

The other of the two is referred to as an Interest Rate Differential (IRD). 

Let’s go over what an Interest Rate Differential is and how penalties are calculated using it.

Why would you want to break your mortgage early?

While it may seem like a bad idea to break your mortgage contract, there are many situations where it makes sense to do so. Most often our clients break their mortgage when they’ll be better off financially by doing so, for example by lowering their monthly mortgage payments. With Perch, we’ll provide you with insights to let you know when you might want to consider breaking your mortgage early.

Common reasons we see for breaking a mortgage early include:

• Rates have decreased (such as in 2020) and borrowers want to lock in a lower rate
• A new addition to the family is expected (or unexpected) and borrowers need to move to a bigger home on short notice
• A new job has come up and borrowers need to move to another location
• The borrower needs to refinance (read why people refinance to learn more), most commonly to pull money out of their home or to lower their mortgage payments

What is an Interest Rate Differential penalty (IRD)?

If your lender doesn’t charge 3 months of interest as a penalty then chances are they use what’s known as an IRD. An Interest Rate Differential is calculated based on the difference between your current mortgage rate and the current market rate that your lender could get for the money they loaned you. For this reason, Interest Rate Differentials are only used with fixed rate mortgages, and only when rates are declining. If you have a variable rate mortgage, your mortgage rate would rise and fall with interest rates and so it wouldn’t make sense to use an IRD. If interest rates have increased since you obtained your mortgage, your lender wouldn’t want to use an IRD, they’d be better off charging you 3 months of current interest and then lending out the funds at the new higher rate.

If you happen to have a fixed rate mortgage in a declining rate environment, here’s how the Interest Rate Differential Penalty is calculated.

The penalty is calculated by subtracting the current market rate from your original mortgage rate to find the interest rate differential, multiplying that by your mortgage principal, and then multiplying it by the months remaining in your mortgage term.

An example of an Interest Rate Differential mortgage penalty

For the purpose of our example, let’s assume you have $500,000 remaining in mortgage principal, you’ve got a mortgage at a fixed rate of 1% and are breaking your mortgage 1 year into your 5 year term after mortgage rates have increased to 3%.

The mortgage penalty for breaking your mortgage will be as follows:

Interest Rate Differential = 3.00% – 1.00% = 2.00%
Principal = $500,000
Time remaining on the mortgage = 48 months

Full calculation: (0.02 * $500,000) / 12 = $833.33
$833.33 * 48 = $40,000

In this situation your mortgage penalty would be $40,000.

If the lender instead charged 3 months of interest the calculation would be as follows:

[(0.01 * $500,000 ) /12 ] * 3 = $1,250

That’s a massive difference! 

For this example it likely wouldn’t make sense for this borrower to break their mortgage this early, but the penalty will drastically go down if rates go back up or the borrower wants to refinance later on in their mortgage term.

Which lenders use Interest Rate Differential?

Generally the big 5 banks tend to use an Interest Rate Differential to calculate mortgage penalty fees. These lenders use current bond yields to calculate mortgage penalty fees which could result in much larger penalty fees than a lender which uses 3 months of interest as a fee. The big 5 banks are as follows:

– Toronto-Dominion Bank (TD)
– Royal Bank of Canada (RBC)
– Bank of Nova Scotia (Scotiabank)
– Bank of Montreal (BMO)
– Canadian Imperial Bank of Commerce (CIBC)

If you want to take advantage of potentially refinancing your mortgage before the end of your term, you might want to consider going with a different lender if you plan on getting a fixed rate mortgage during a time when interest rates are likely to decrease.

Check out our interest rate forecast for an up to date outlook on the mortgage market, including where our analysts predict rates will go over the next 5 years.