Two Penalty Calculation Methods: 3 Months vs IRD

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In Canada, prepayment penalties on a fixed-rate mortgage are calculated using two methods: the three months' interest penalty and the interest rate differential (IRD). The three months' interest method is straightforward: multiply the remaining mortgage balance by the annual contractual rate, then divide by four. The IRD is more complex: it measures the gap between the borrower's contractual rate and the rate the lender currently offers for a term matching the remaining contract duration. This gap is multiplied by the remaining balance and the number of months remaining, then divided by twelve. The lender applies whichever of the two calculations produces the higher amount. When interest rates have dropped significantly since signing, the IRD can be considerably higher than three months' interest. OSFI requires fédéral lenders to clearly disclose the method used. Each lender may have its own IRD calculation variant, which explains the significant differences between institutions.

The Two Penalty Calculation Methods in Canada

When a borrower wants to break a fixed-rate mortgage before the end of the term, the lender calculates the penalty using two methods and applies whichever is higher. This rule is standard for Canadian financial institutions, whether fédéral (under OSFI supervision) or provincial.

Method 1: Three Months' Interest

The three months' interest method is the simplest. The formula is: Remaining mortgage balance x Annual contractual rate / 4. For example, on a $350,000 balance at a contractual rate of 4.50%, the penalty would be $350,000 x 0.045 / 4 = $3,937.50. This method does not account for the remaining term or rate changes.

Method 2: Interest Rate Differential (IRD)

The IRD measures the cost to the lender of reinvesting the funds at a lower rate for the remaining term. The general formula is: (Contractual rate - Comparison rate) x Remaining balance x Months remaining / 12. The comparison rate is the lender's current rate for a new term equal to your mortgage's remaining duration.

Concrete Comparison With an Example

Starting data: $300,000 balance, 5.00% contractual rate, 36 months remaining. The current 3-year posted rate is 4.50%, the current 3-year discounted rate is 3.50%.
Three months' interest: $300,000 x 5.00% / 4 = $3,750.
IRD with posted rate (big banks): (5.00% - 4.50%) x $300,000 x 36/12 = $4,500. The lender applies $4,500.
IRD with discounted rate (monolines): (5.00% - 3.50%) x $300,000 x 36/12 = $13,500. NOTE: if the lender uses the lower discounted rate, the IRD is paradoxically higher because the gap is larger. In this case, monoline lenders often cap the IRD at the actual loss amount.

This example illustrates why it is essential to understand which method your lender uses and what comparison rate they apply. An AMF-certified mortgage broker can help you decode your contract clauses and estimate your actual penalty before any refinancing decision.

Frequently Asked Questions

How is the three months' interest penalty calculated?

Multiply the remaining mortgage balance by the annual contractual interest rate, then divide by four (representing three months out of twelve). For example, on a $300,000 balance at 5%, the penalty would be: $300,000 x 0.05 / 4 = $3,750.

How does the interest rate differential (IRD) calculation work?

The IRD calculates the gap between your contractual rate and the lender's current rate for a term equal to the remaining duration. This gap is applied to your balance for each month remaining. For example, if your rate is 5%, the current rate is 3% for the remaining duration, and 24 months remain on a $300,000 balance, the IRD would be: (0.05 - 0.03) x $300,000 x 24/12 = $12,000.

Why is the IRD often much higher than three months' interest?

Because the IRD accounts for the entire remaining duration and the rate gap. The larger the rate drop and the more months remaining in the term, the higher the IRD. Three months' interest only considers the current rate and three months of duration, regardless of the gap or remaining term.

Do all lenders use the same IRD formula?

No. Each lender has its own variant. Big banks often use the posted rate as their reference, producing a larger gap. Monoline lenders generally use the discounted rate, giving a fairer, lower result. OSFI requires disclosure of the method but does not standardize the calculation.

Is the penalty always the maximum of the two methods?

For fixed-rate mortgages, yes: the lender applies whichever is higher between three months' interest and the IRD. For variable-rate mortgages, it is almost always three months' interest only. Always verify the specific conditions in your mortgage contract.