Comparing Mortgage Offers: Rates, Prepayments, Penalties and Fine Print

Two mortgage offers with nearly the same rate can cost very different amounts once the fine print comes into play. Here is what to compare beyond the rate, what lenders have to disclose in writing, and a worked example of how a lower rate can cost more.

The short version

Compare like with like

The Financial Consumer Agency of Canada (FCAC) notes that lenders may have different rates and conditions for similar products, and that you may be able to negotiate a lower rate. Ask each lender, or your broker, for a written quote on the same mortgage:

• The same amount and amortization. A longer amortization lowers the payment but adds interest.
• The same term and rate type. A three-year fixed, a five-year fixed and a variable rate are different products. I compare terms in Choosing a Mortgage Term.
• The rate hold. FCAC says a pre-approval may lock in a rate for 60 to 130 days, depending on the lender. Ask how long it lasts, whether you get a lower rate if rates fall before you close, and whether it can be extended.

Prepayment privileges

Closed mortgages usually limit how much extra you can pay each year without a penalty, and FCAC notes that the privileges vary from lender to lender, with some lenders allowing none. Compare:

• The lump sum. How much you can pay down each year, and whether it is a share of the original amount or of the balance.
• Payment increases. How much you can raise your payment, and how often.
• The fine print. Whether unused room carries over, and whether you can use your yearly privilege just before you pay the mortgage off, which FCAC suggests to reduce a penalty.

I explain prepayments in Paying Off Your Mortgage Faster.

How a penalty would be worked out

If you break a closed mortgage early, FCAC says the penalty will usually be the higher of three months' interest and the interest rate differential (IRD), which lenders usually use when your rate is higher than current rates and you signed less than five years ago. The IRD compares the interest left in your term at your rate with the interest at a comparison rate, and FCAC describes two choices for that rate:

• The current posted rate. The lender's posted rate when you break the mortgage, for a term similar in length to the time you have left.
• The posted rate minus your discount. The same posted rate, less the discount you were given when you signed. TD and RBC describe theirs this way. The bigger your discount, the larger the IRD.

On a closed variable rate, though, TD and RBC both say the penalty is generally three months' interest. Either way, FCAC notes you may also pay an administration fee. Ask each lender for a sample penalty calculation, and see Moving Before Your Mortgage Term Ends for how penalties play out when you sell.

Portability and registration

• Portability. A portable mortgage lets you transfer your balance, rate and terms to your next home. FCAC suggests asking whether yours is eligible and what restrictions apply, and notes you may pay a penalty if the new home costs less than your mortgage. Ask how much time you have between selling and buying.
• Blending. If your next home needs a bigger mortgage, ask how the lender would price the extra money, for example with a blended rate.
• Standard or collateral charge. A standard charge only secures the mortgage. A collateral charge may be registered for more than you borrow, so you may be able to borrow again without a new registration, but switching lenders can mean fees to replace it, and every loan it secures must be repaid or transferred. I cover both in Collateral Charge Mortgages.

Cash back and fees

FCAC describes cash back as an optional feature that usually comes with a higher rate, and says your lender may ask you to repay some or all of it, typically if you break the mortgage before the end of the term. RBC, for example, says you will have to repay a portion if you prepay the mortgage before the term ends.

To judge a cash-back offer, set the cash against the extra interest. On a $600,000 mortgage over 25 years, 3% cash back is $18,000. At an example rate of 4.99% instead of 4.19%, you would pay about $23,000 more interest over a five-year term, so the cash back comes out about $5,000 behind, before anything you might repay if you leave early.

Ask for every fee in writing too: any appraisal or administration fee, the discharge fee when you pay the mortgage off, and whether the lender covers any costs.

Renewal practices

Your rate only lasts for the term. A federally regulated lender must send a renewal statement at least 21 days before your term ends, and FCAC notes that your mortgage may renew automatically if you don't act, and that you may qualify for a lower rate than the one in your renewal letter. Ask each lender how early you can renew without a charge and whether it renews automatically. I explain the timing in Renewing Your Mortgage.

What the lender has to disclose

FCAC says a federally regulated lender, such as a bank or a federal credit union, must set out the key terms in an information box at the beginning of your mortgage agreement and disclose them in clear, simple language that isn't misleading. Look for:

• The basics. The amount you're borrowing, the annual interest rate, the term, the amortization and your payments.
• The cost. The cost of borrowing over the term and, if it differs from the interest rate, the annual percentage rate (APR): the annual cost as a percentage of what you borrow.
• Prepayments. What you can prepay without a penalty, the penalty charges and a brief explanation of how they are calculated.
• Other charges. Any default insurance cost, other charges, and whether there is a discharge fee and its amount.

If your lender isn't federally regulated, such as a provincially regulated BC credit union, BC's Business Practices and Consumer Protection Act generally requires a disclosure statement for a consumer mortgage at least 2 business days before you take on any obligation or make any payment in connection with it, unless you waive that period. It must show the APR, the total cost of credit, other charges and any conditions and charges for prepaying. Ask for them early, so you can compare side by side.

A worked comparison

Say you're comparing two five-year fixed offers on a $600,000 mortgage over 25 years. These are example figures, compounded semi-annually, with a simplified penalty (the balance times the rate gap times the years left):

• Offer A: 4.19%. $3,218.22 a month. The penalty uses the posted rate minus your discount; the posted five-year rate was 6.09% when you signed, a discount of 1.90 points.
• Offer B: 4.29%. $3,251.15 a month, about $33 more. The penalty compares your rate with the current posted rate.

Over the full five years, Offer A saves about $2,870 in interest. But say you sell after two years, with about $571,500 owing and 36 months left, when the posted three-year rate is 5.49%:

• Offer A. The comparison rate is 3.59% (5.49% minus 1.90), so the IRD is about $10,290, well above three months' interest of about $5,990.
• Offer B. Your rate is below 5.49%, so there is no IRD, and the penalty is three months' interest, about $6,130.

Offer A saved about $1,170 in interest over those two years but costs about $4,150 more to break, so Offer B comes out about $2,990 ahead. If you might move or refinance during the term, the penalty method can matter more than a tenth of a point on the rate.

Questions buyers often ask me

Is the lowest mortgage rate always the best offer?

Not always. Prepayment privileges, the penalty method, portability, cash back and fees can outweigh a small difference in rate, especially if you might sell or refinance before the term ends.

What is the interest rate differential?

It is one way to work out the penalty for breaking a fixed-rate mortgage early: roughly the interest left in your term at your rate, minus the interest at a comparison rate. You usually pay the higher of the IRD and three months' interest.

Do I have to pay back cash back if I break my mortgage?

Often, yes. FCAC says your lender may ask you to repay some or all of it, typically if you break the mortgage before the end of the term, so read the repayment terms first.

What does a lender have to tell me in writing?

A federally regulated lender must give you an information box with the rate, APR, term, payments, prepayment privileges, penalties and other charges. In BC, a lender that isn't federally regulated generally has to give you a cost of credit disclosure at least 2 business days before you take on the mortgage, unless you waive that period.

How long will a lender hold a rate for me?

FCAC says a pre-approval may lock in a rate for 60 to 130 days, depending on the lender. Ask how long the guarantee lasts, whether you get a lower rate if rates fall, and whether it can be extended.

Shopping for a mortgage? Read Mortgage Broker or Bank? and Fixed or Variable?, or try my mortgage calculator.

This article is general information, not financial advice. The examples use example rates, compounded semi-annually, with a simplified penalty calculation; they are illustrations, not quotes, and your own contract sets the rules. The details come from the Financial Consumer Agency of Canada, BC's Business Practices and Consumer Protection Act and lenders' own websites, and were current at the time of writing. For FCAC's guide, see choosing a mortgage.