The Interest Rate Differential (IRD), is a prepayment penalty, levied by lenders if you pay off your fixed rate mortgage before it matures or if you pay off principal, beyond the amount allowed by your prepayment privilege.
On variable-rate mortgages the prepayment penalty is often three months interest. However, with a fixed-rate mortgages, the penalty is the greater of three months interest or the Interest Rate Differential (IRD).
The IRD is based on: The amount you are pre-paying; and, an interest rate difference between your original mortgage interest rate and the interest rate that the lender can charge today when lending the funds for the remaining term of the mortgage.
For example, with a 5-year 3.5% fixed rate mortgage, you promised the lender to pay 3.5% for five years. If you decide to break that arrangement after three years the lender gets the remaining money back to re-lend. To match the original term, the lender wants to get the same interest rate on the remaining two years.
Lender will calculate how much less interest they will receive over the remaining term at the lower reinvestment rate compared to your promise of 3.5%. Assuming the reinvestment rate is close to 3.5%, you would pay three months interest.
The big difference between big banks (RBC, CIBC, BMO, etc) and non-bank lenders (monoline mortgage lenders, credit unions, insurance companies) is that the non bank lenders calculate the difference between your original rate and the current rate for the remaining term, generally resulting in a penalty of 3 months interest.
The banks calculate IRD differently. If the original “posted” rate was 5.5% but they did you a favor and only charged you 3.5%, the IRD would be calculated between 5.5% and the reinvestment rate, which increases the penalty massively. In this example, (5.5%-3.5%) 2% per year for the remaining term of the mortgage.
Bottom line is that your really want to give your head a good shake and consider if a potential penalty of 5-10% of your mortgage balance is a good idea before getting into a fixed rate mortgage with a Canadian Bank.
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