Mortgage rates are near three-year lows. That sounds like great news — unless your idea of “great” includes surprise fees and weeping over your amortization schedule.

For many big bank borrowers, falling rates are actually a double-edged sword.

That’s because falling rates trigger break penalties that banks calculate using “interest rate differentials” (IRDs) — a term that roughly translates to “math designed to make you cry.”

These IRD charges are essentially based on fake rates, and it costs Canadians billions every year.

We could pull several names from a hat as examples, but let’s consider Toronto Dominon Bank today, and here’s why:

On Wednesday, TD took a chainsaw to its publicly posted rates. Its two-year fixed rate nose-dived 195 basis points, just about the most I’ve ever seen.

If you have the misfortune of breaking a TD mortgage right now, it’s possible that rate drop just showed up with a vacuum and emptied your bank account.

Let’s look at an example:

For a TD borrower breaking a three-year fixed rate with around 29 months to go and a $500,000 balance, that 195 basis point drop could potentially cause their penalty to go from roughly $5,600 (three months of interest) to well over $17,000, according to Matt Imhoff of Prepayment Penalty Mentor.

This lovely little charge is based on the aforementioned IRD calculation. In essence, that sweet discount you bragged about when signing the mortgage? Yeah, the bank keeps the receipt and weaponizes it the minute you try to leave.

What they do is this: the bank takes the discount you got off their already-fictional posted rate, subtracts it from today’s posted rate (now rebranded as a “comparison rate” — cute) and pits that against your actual contract rate.

The difference between your rate and the comparison rate is the IRD, and that is what you’ll be charged on your full balance for each year remaining on your mortgage contract.

The problem is that bank comparison rates are made up because, well, posted rates are made up.

And the more of a “deal” you got up front, the worse it becomes — because that discount lowers the so-called comparison rate, which is what the bank claims it could earn if they reloaned your money.

And there’s no consistency. It’s like a menu where the same dish is three different prices depending on what table you’re sitting at.

For example, if you look at a trio of similar mortgages, each with different terms but all with just under two years remaining, “TD is essentially telling customers three different stories,” Imhoff says. It’s effectively saying it can only earn about:

• 4.8 per cent if you’re breaking a five-year fixed
• 3.1 per cent if you’re breaking a four-year fixed
• 2.4 per cent if you’re breaking a three-year fixed

But that makes no sense. If you have two years remaining in all cases, the bank should earn the same amount in each of them. (Note: These are ballpark numbers for illustrative purposes.)

Canada’s government — bless its bureaucratic blindfold — continues to whistle past this mess like it’s not draining household wealth, turning a regulatory blind eye to a financial sleight of hand.

It’s well past time for politicians to stop playing spectator and actually legislate some basic reason and transparency into prepayment charges, so families breaking a mortgage don’t feel like they’ve triggered a trapdoor in a contract written by, well, a bank.

Of course, if banks are forced to charge penalties that more reasonably reflect their losses from prepayments, they’ll simply boost rates or fees to replace the golden penalty goose.

Why banks charge penalties

The primary purpose of prepayment charges (a.k.a. “mortgage penalties”) is supposed to be to make lenders whole for costs they incur when you don’t complete your contractual term.

That’s fair. After all, banks face legitimate reinvestment costs when you break a mortgage contract.

But some lenders take it well beyond that, demanding breakage penalties so bloated they don’t just recoup losses, they pad margins like it’s bonus season at the penalty department.

They do this to make money, avoid prepayment hedging costs and discourage mortgage customers from leaving.

Instead of judging your breakage penalty based on the real-life rates they can relend at, big banks base their comparison rates on make-believe rates that are frequently far below market offers. The result is often an IRD far bigger than it should be.

And I stress that TD, which otherwise has solid products and rates, is hardly the lone wolf when it comes to inflated prepayment penalties. I could’ve just as easily pointed to BMO, CIBC, RBC, Scotiabank, National Bank, and a bunch of other lenders and credit unions as examples.

In fairness, banks do offer some escape hatches. TD, for example, allows borrowers to port mortgages to a new property or renew early (if near maturity) without penalties. Some lenders also let you tack on extra borrowing without penalty if you have what’s called a combined loan plan (CLP).

However, if you find yourself in the unenviable position where:

(A) you need to break a standard bank mortgage early because of a life event (e.g., divorce), the need to sell and rent, the need to change lenders to consolidate debt, health issues, or some other urgent need for cash, and
(B) posted rates have fallen since you got your mortgage; then brace yourself, because your wallet is about to be treated like it lost a bar fight in a parking lot.

Five parting tips

1. Always consider your lender’s prepayment formula before refinancing. Sometimes it pays to accelerate a refinance to avoid being subject to more expensive comparison rates. Conversely, sometimes it pays to defer a refinance. This is where a seasoned mortgage broker really earns their keep. But not all brokers are proficient at this math, so choose wisely.
2. Consider making a prepayment if possible to reduce the balance used to calculate your penalty. Just be sure to do it far enough in advance (e.g., at least a month before exiting the mortgage) and make sure it reflects online before you request a payout statement from the lender.
3. Ask for a payout statement as soon as possible to lock in the penalty — important in a falling rate market.
4. Sometimes it even makes sense to break the mortgage, pay the penalty and move into an open term, to avoid worsening penalties.
5. Seek out lenders with fair penalties if you want more flexibility. A broker can give you a list, but sample names include Manulife Bank, First National, MCAP, Merix Financial and RFA Bank to name a few. You may (or may not) pay a bit more for the mortgage up front, but you could make that back three or four-fold if you ever need to break the mortgage early.

Robert McLister is a mortgage strategist, interest rate analyst and editor of MortgageLogic.news. You can follow him on X at @RobMcLister.

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