What is A Closed Mortgage
A Closed Mortgage is a mortgage where the term of the mortgage is for a fixed period of time and usually comes with a lower interest rate. This is great if you are looking to save money during the term of the mortgage.
The pitfall comes in when you look to payoff or “break” the mortgage before the term is up. Generally speaking, the penalty will be the greater of an amount equal to three (3) months interest or the Interest Rate Differential (“IRD”).
The IRD can be described as an amount equal to the interest rate that equals the difference between your original mortgage interest rate and the interest rate that the lender can charge today when re-lending the funds for the remaining term of the mortgage.
For example, say your current interest rate is 3.5% and the amount outstanding under your mortgage is $500,000.00 and there are two (2) years left under your mortgage. If current mortgage rates for a two (2) year fixed closed term are 2.00%, there is a difference of 1.5%. You take that difference (1.5%) and multiply that by the balance outstanding. In this case, that would mean $7,500.00.
The above is not insignificant. Sometimes I find that I have a client that has entered into the sale of their home without factoring the pre-payment penalty into their financial calculations. The problem becomes apparent once the Agreement of Purchase and Sale has been signed and finalized and we as lawyers, on behalf of our client, request a mortgage discharge statement from the seller’s financial institution and the statement shows the pre-payment penalty.
Once the seller learns of the penalty from the discharge statement, it may be too late, for at that point the seller only has two options; pay the penalty or renege on the sale. If the seller chooses to back out of the sale transaction, they may face a claim for breach under the Agreement of Purchase and Sale and may be liable for damages that the prospective purchaser may incur on mitigating their damages. In such case, the damages may exceed the cost of the pre-payment penalty due under the mortgage.
Sometimes if the seller is buying a new home and is taking out a larger mortgage, the penalty can be negotiated and in some instances reduced. On the other hand, I have had clients who have had the unfortunate experience selling their home, as they were facing financial difficulty, and we’re going to rent a place and just before closing they found out that the bank was charging them a $23,000.00 prepayment penalty. This made the entire purpose of the transaction unfeasible and left my clients with little choice but to proceed with the closing and paying the penalty.
The above is just one issue to take into consideration when selling your home. Given the various issues that may affect a seller when selling their home, I strongly encourage all prospective purchasers and sellers to speak with their legal advisors prior to proceeding. A simple conversation can save a person from an expensive misstep.
Hummingbird Lawyers LLP has two offices for your convenience. Providing qualified, skilled and experienced lawyers in Toronto and lawyers in Vaughan, we are committed to giving our clients the convenience, expertise and guidance they need. For questions regarding closing a mortgage please reach out to our team of lawyers for real estate.
Andrew Fortis is a certified real estate lawyer in Ontario.
You are correct, and furthermore, some banks use their “posted rate” to calculate the IRD, which magnifies the penalty amount. This is one of the reasons it can be advantageous to be professionally represented when obtaining real estate financing. The “terms” of the transaction include much more than the time duration and the interest rate. As with any contractual agreement, it is critical to understand all conditions which apply and to choose based on full knowledge of which ones are best suited in each case.
Thank you for bringing this important issue to your audience, Andrew.