Interest Rate Differential Explained
How do banks calculate the penalty for your fixed rate mortgage? It’s by using the interest rate differential calculation and I’m going to explain it right now!
When it comes to calculating the penalty for a fixed rate mortgage, it’s a complicated formula but I hope that by the end of this blog post, you’ll have a better understanding of how it’s calculated and how banks use it to artificially inflate the penalty.
Have you ever wondered why banks disclose a posted rate? It’s often much higher. If you go to RBC’s posted rates, the 5-year closed rate is 4.79%. That’s actually the rate they’re offering. But of course, that’s actually not what you’ll get since there’s so much competition in the market. What you’ll get is, for the purpose of this example, say 2.79%.
So essentially, from the bank’s point of view, they’re giving you a discounted rate. The discount is 4.79% - 2.79% = which works out to be 2.00%
The mortgage amount in this example is $300,000. You’ve got 2 more years left in your 5-year term mortgage and you’re going to sell your property and payout your mortgage.
But, rates are now much lower now. Since you’ve got 2 years left, the bank will look at what the 2 year rate is and it’s now say 1.79%. Which means there’s a difference of 1%.
So let’s work out the math together.
$300,000 * 2% and an additional 1% = 3% and that works out to be $9,000.00
But that’s only for 1 year, there’s 2 years left. So we’ll need to multiply that $9000 by 2. And we get $18,000.00
For this example, the penalty is a whopping $18,000!
So how can we avoid all this? 2 ways - One way is to choose a mortgage company that doesn’t have a posted rate. Another name for these mortgage companies are called monolines. You may or may not have heard of them but popular names like First National, MCAP, RMG would fall into this category. The penalty for these lenders are lower because they don’t have a posted rate. So there’s no artificial discount that would increase the penalty.
Another way to avoid this is to choose a variable rate mortgage. Variable rate mortgages don’t use the interest rate differential formula to calculate the penalty. It’s simply a 3 months interest penalty and it works out to be many times lower than fixed rate mortgages. For our example, say the variable rate you currently have is 2.79%. The 3 months penalty will only be around $2,100.00. Much better than paying $18,000!
And there you go! This is how interest rate differential works when calculating a fixed rate mortgage.
If you have any questions, please don't hesitate to email us at email@example.com and we'd love to help!