All mortgage brokers should have a comfortable working knowledge of how prepayment penalties are calculated and applied.
Our clients depend on us to know the ins and outs of these often-significant penalties in order to minimize the cost for them—or better yet, to help them avoid penalties altogether.
Prepayment penalties can be a daunting topic for any mortgage professional. It involves knowing individual lender policies, not to mention a fair share of math.
But it doesn’t need to be complicated. Below I’m going to explain some ways to help increase your comfort level with calculating prepayment penalties—without a prepayment calculator—as well as the mechanics and reasoning behind them.
Prepayment penalty policy = the lender’s return policy
Not a single mortgage consumer likes the thought of having to pay a mortgage penalty. But as brokers, it’s our job to inform clients why they exist and how they are crucial from a lender’s perspective.
When we buy an appliance, a mattress or even clothing, we are presented in simple terms what the costs will be if we decide to return the product. Whether it’s a restocking fee, a 100-day sleep guarantee, or a 30-day exchange policy, we’re told the terms upfront.
We know what we are committing to so we can feel as comfortable as possible with our decision.
Those selling such products are intimately familiar with these policies when it comes to having their product returned. No one wants an unhappy customer.
With mortgages, the prepayment penalty policy is essentially the lender’s return policy that applies to closed-term mortgages.
When are prepayment penalties applied?
Now that we understand why we have prepayment penalties, let’s look at how they differ by mortgage product:
With an open mortgage, you pay a higher interest rate in exchange for the flexibility to pay off your mortgage in full at any point without penalty.
Open mortgages are common for those looking for short-term financing solutions when the borrower intends to pay off the loan before the end of the term.
Closed variable-rate mortgages
The prepayment penalty on variable-rate products with a closed term is typically three months’ interest. Where it can differ is with the interest rate being used for the calculation.
Most lenders use the current contract rate with the discount received off of prime, while some lenders use their prime rate.
On a $500,000 mortgage, prime – 1.00% can mean an additional $1,250 when using prime rate for the three months’ interest calculation.
Closed fixed-rate mortgages
The prepayment penalty for fixed-rate mortgages with a closed term is typically the greater of three months’ interest or the Interest Rate Differential (IRD).
An IRD penalty ensures that the lender is compensated for their interest losses when they re-loan the mortgage funds at a lower rate than the existing mortgage for the remainder of the mortgage term.
In a rising interest-rate environment where the lender could re-loan the mortgage funds at a higher rate, prepayment penalties tend to be limited to three months’ interest. Decreasing interest-rate environments tend to produce larger IRD penalties, especially for contracts with years remaining on the mortgage term.
Breaking down the Interest Rate Differential
Interest rate differential can be seen as the “interest to maturity” minus the “reinvestment interest to maturity.”
With closed fixed-rate mortgages, the IRD is always being calculated, even when it is less than three months’ interest. Even when the IRD is zero or a negative value, it’s still being calculated.
By knowing your interest rate, remaining term, balance, amortization, and payment frequency, the interest to maturity can be calculated using an amortization summary at any point during your term.
Increase your payment and/or make a lump-sum payment and the interest to maturity will decrease. It will also lower the reinvestment interest to maturity, which means a lower IRD than if you didn’t use a prepayment privilege.
In order to simplify things, we are going to ignore compounding interest and amortization for our quick calculation:
Interest Rate Difference (%) x Remaining Term (Years) = Interest Rate Differential (Expressed as a percentage of balance)
Tip: The Interest Rate Difference is the difference between the contract rate and the reinvestment interest rate for a mortgage of a similar term.
How prepayment penalties are calculated based on lender type
Monolines tend to compare your contract rate to the actual rates being offered for similar products under the categories of insured, insurable and conventional.
If your contract rate is 5% and the reinvestment interest rate is 4%, then the Interest Rate Difference is:
Contract Rate (5%) – Reinvestment Interest Rate (4%) = 1%
Banks set up their calculations in a way that requires some additional math.
They publicize posted rates, but typically give the borrower a discount. An insured mortgage is more likely to have a greater discount than a conventional mortgage, for example.
Initial Posted Rate (6%) – Discount (1%) = Contract Rate (5%)
If the similar term’s posted rate is currently 5%, then the Interest Rate Difference is:
Contract Rate (5%) – Similar-term Posted Rate (5%) – Discount (1%) = 1%
In this example, the reinvestment interest rate can be seen as:
Similar-term Posted Rate (5%) – Discount (1%) = 4%
Determining the closest comparable term
Most lenders have a chart that helps you to determine the comparable term based on the time remaining on the existing mortgage. That means there are set dates where a known change to the reinvestment interest rate could occur.
Determining the reinvestment interest rate
The biggest challenge for many brokers is knowing how to find and calculate the reinvestment interest rate and knowing how it can change over time.
There are only two ways it can change:
The remaining term decreases to cause a change to the closest comparable term
The lender changes its reinvestment interest rate/posted rate
The dates in which the closest comparable term changes is not a surprise, so we can be proactive in order to help our clients.
For reinvestment interest rates, they can change at any time, though we generally know if they are trending up or down based on the bond markets.
When the reinvestment interest rate is considerably lower than your actual contract rate, we tend to see larger IRD prepayment penalties. Especially when the borrower has years remaining on their mortgage term.
Imagine that your client decided to break their mortgage on day one of the contract. What kind of prepayment penalty would they be facing?
If it’s an IRD, then your lender has most likely used reinvestment interest rates that are not tied to any of their actual mortgage products.
By definition, the prepayment penalty should be three months’ interest on day one, not an IRD. If a lender is poised to charge you an IRD day one, then they are using reinvestment interest rates that are considerably lower than their product offerings.
If you are not in IRD territory on day one, what about after a year or two based on today’s factors?
Using today’s interest rates/reinvestment interest rates, we are tracking only a three-month interest penalty with some lenders at every point over the course of the mortgage term. In order to see an IRD that is greater than three months’ interest we would have to see their reinvestment interest rates decrease.
With banks, we tend to be in IRD territory after six months, once the comparable interest rate is lower than the original mortgage term. In general, the reinvestment interest rates for shorter terms tends to be lower than longer terms. The exception would be one-year or six-month terms.
What does this all mean?
Before we even consider recommending a lender for our clients, we need to have a complete understanding of how their reinvestment interest rates are calculated and where they are posted. We need to understand the lender’s return policy.
How do they change over the course of a mortgage term in stable, rising and decreasing interest rate environments? Are we looking at a large IRD on day one or do we need to see time pass or lowering rate pressure before an IRD greater than three months’ interest is created?
Knowing these answers allows us to be proactive to our clients’ needs instead of being reactive. The last thing we want is an upset client when they see the true cost of returning their mortgage early.
Opinion pieces and views expressed are those of respective contributors and do not represent the views of the publisher and its affiliates.
This article was first published in Perspectives magazine (Issue #1, 2023)