The hidden cost of great rates: explaining the IRD

The hidden cost of great rates: explaining the IRD

The hidden cost of great rates: explaining the IRD

The number of consumer complaints related to mortgage renegotiations is rising due to confusion over penalties, according to a report in the Montreal Gazette.

Option Consommateurs, a non-profit consumer rights group in Quebec, told the Gazette that since interest rates began to fall in January they've received dozens of calls from consumers unsure about how much they will have to owe financial institutions if they break their current mortgage.

The Financial Consumer Agency of Canada told the paper it received 80 mortgage penalty-related complaints since January and has decided to investigate 16 compliance cases. Lawyer Dominique Gervais told the paper that the confusion is over the Interest Rate Differential (IRD) because most consumers think they will only be penalized three months of interest.

"These [IRD] clauses are legal," Gervais said. "But we think that in many cases, the banks are going too far because they are making their calculation on the basis of what the posted rate was at the time of the loan and not on any discounted rate that was agreed upon with the customer."

She added that not all financial institutions calculate IRD in the same way and the only time financial institutions can't use the IRD is on a mortgage with a more than five-year term after five years has already passed.

But consumer rights groups aren't the only ones getting complaints, as a lot of homeowners are going directly to lenders, CMP has learned.

"We are getting a lot of calls from borrowers who had no idea about the Interest Rate Differential," said Laura Tomulka, a mortgage specialist at First National Financial. "They are shocked that they weren't told about this fee by their mortgage specialist."

In fact, she adds, many mortgage specialists don't fully understand how the IRD works themselves, which would explain why clients are calling lenders to complain about the "surprise" fee. Basically, the IRD comes into effect when interest rates drop as much as they have in the last few months and homeowners opt to renew early, switch lenders or even pay off their mortgage outside of regular pre-payment terms. Lenders charge a fee to make up for the loss of profit between the previously higher rate and the new lower one.

It's something mortgage broker Neil McJannet, with Canadawide Mortgages in Abbotsford B.C., has been telling his clients for years.

"I tell every one of my clients that there are two penalties - the three months interest, which everyone seems to know about, and the IRD, which historically always comes back," said the ex-banker turned broker. "No one ever expects they'll be hit with something this big, and we've really only seen it twice in the last five years (once following the World Trade Center attacks and again with the recent economic slowdown). It can raise its head whenever it wants."

He said the IRD was created in the '80s when rates were so high and "everyone wanted out," leaving the lenders to come up with a way to make their money back. Part of the reason why many mortgage professionals don't seem to know enough about it is that in the U.S. there is no such thing as IRD.

"If you've taken courses or read books from America, which works on a points system instead, then of course there isn't going to be any mention of it," he said.

McJannet devised an excel spreadsheet the last time IRDs were common which he e-mails out to clients explaining how it works. Simply put, it's "when rates go down, the IRD goes up," he said, and the actual calculation isn't much more difficult to anyone with excel or a calculator.

First, take the principal balance, multiply it by the difference between the previous high interest rate and the newer low interest rate [i.e. if the rate was 5.5 per cent, but now is 3.5 per cent, this number would be two] and divide that by 12. Multiply that number by the remaining months on the mortgage term to get the approximate IRD payment owed. Most lenders will either take that, or three months interest, whichever is greater.

Before recommending to any client whether or not to keep their higher rate or renegotiate for a lower one, Tomulka will first calculate the IRD penalty, then determine how much interest would be paid over the course of the mortgage at the current rate and compare that to the interest that would be paid with the newer rate.

"If the IRD fee is less than the savings between the two rates then it's worth renegotiating," she said. "If not, then perhaps making a lump sum for the same amount and keeping your old rate would be more beneficial to the client."

McJannet performs a similar service for his clients, and said it's worth it for about only 20 per cent of them.

"If someone has received an inheritance, for instance, and wants to pay their mortgage off early but faces a penalty larger than what they would save in interest, I tell them to put it in the bank," he says, adding that "there is no forgiveness when it comes to the IRD. Even if the client is doing something like selling their property, lenders need to make up that money, so it's always something that should be calculated and considered."

Not only is the calculation easy, but it's something all mortgage professionals should be doing in order to help make the best choice for their clients.