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Pre-Payment Penalty: Interest Rate Differential (IRD)
July 2, 2024 | Posted by: Bailey Coats
When paying off a variable rate mortgage, most lenders will charge a pre-payment penalty of 3 months of interest at the mortgage's current interest rate.
When paying off a fixed rate mortgage, generally most lenders will charge a pre-payment penalty that is the GREATER OF either 3 months of interest at the mortgage's current interest rate OR an interest rate differential (IRD).
There are multiple ways that an IRD can be calculated. Here are the most common examples:
Posted Rate Method – Usually used by Banks and Credit Unions.
The lenders' posted rate is used to calculate the penalty. It also factors in any discounts the borrower received. These rates will usually be posted on the lenders website with a discount amount and then a final rate. Rarely does anyone not get a discount off the posted rate. Here is how an IRD could be calculated:
Posted Rate for a five-year term: 4.80%
Borrower was given a discount of: 1.80%
Meaning the borrower has a rate of 3.00% on a five year fixed mortgage.
The borrower wants to payoff their mortgage at the 3 year point, leaving 2 years left on the current term. The posted rate for a 2 year fixed at the time of the mortgage being paid off is 3.50%. (There is a rate discount of 1.25% meaning the published rate would be 2.25%, however this is not applicable to the calculation.)
The bank will subtract the discount from the posted 2 year fixed rate:
3.50% (current posted rate) - 1.80% (rate discount given on existing rate) = 1.70% (IRD rate)
They then take that rate and multiply it by the number of years remaining:
1.70 (IRD rate) x 3 (years) = 5.10% of the mortgage.
On a mortgage of $300,000 that equals a penalty of $15,300.
Published Rate Method – Usually used by Monoline Lenders.
This is sometimes referred to as a 'fair penalty' as it uses lender published rates. These rates are usually more reasonable as they are what borrowers would actually be paying on a new mortgage.
The borrower has a rate of 3.00% on a five year fixed mortgage.
The borrower wants to payoff their mortgage at the 3 year point, leaving 2 years left on the current term. The current rate for a 2 year fixed at the time of the mortgage being paid off is 2.50%.
3.00% (existing rate) - 2.25% (current published rate) = 0.75% x 3 (years) = 2.25% of the mortgage.
On a mortgage of $300,000 that equals a penalty of $6,750.
**These calculations are for easy demonstration purposes only. Exact formulas may differ from lender to lender. To ensure accuracy please consult with your individual lender to obtain pre-payment charges and the formula they are calculated with.**
