How to calculate interest rate differential (IRD)

calculate interest rate differential

The IRD is a financial penalty that may apply if you pay off your mortgage early, pay down the principal beyond what your terms allow, or break your mortgage for any reason before the term ends. The interest rate differential (IRD) is the difference between the interest rates on your current mortgage vs the interest rate that the lender can charge today.

What’s The Interest Rate Differential Based On?

The IRD is based on 2 main factors:

  1. The amount you are pre-paying
  2. An interest rate the equals the difference between your original mortgage interest rate and the interest rate that the lender can charge today

How Is Interest Rate Differential Calculated?

The interest rate differential calculation is complex and has values that can change daily as it encompasses the remaining time in your mortgage term, the current market rates, and the outstanding balance. It is important to note that there is a significant difference between how a bank will calculate this compared to a monoline lender. 

Typically, when you break a mortgage with a monoline lender you will incur a penalty of around 1% of the outstanding balance where with a bank it is around 4%. The reason for this is due to the way the interest rate differential is calculated through the “posted” rate. The banks have a posted rate that is significantly higher than the rate you will receive for a mortgage, however with a monoline lender the posted rate is the same as the one you receive. With a bank they offer you a “discount” off the posted rate so if you break your mortgage you need to cover the spread.

IRD Calculation Example

Lets use a simple example to showcase this. You just took out a mortgage for $400k at a rate of 2% with a bank who has a posted rate of 5% and you decide to break it the next day. You will need to cover the spread between the posted rate of 5% and the rate you received 2%, which in this case equals 3%. 

When we take 3% of $400k we realize that the penalty is $12k to break this mortgage. Let’s look at this with a monoline lender. If you received a rate of 2%, then the posted rate would also be 2%. When you subtract the two they would cancel out and equal

0. When this occurs, the lender will have a minimum penalty of 3 months of interest (not 3 months of mortgage payments). 

When a 3-month interest penalty occurs it typically works out to be 1% of the mortgage amount or in this case around $4k. Although we may purchase a home thinking we will never break the mortgage, we need to understand that life happens. It is always a good idea to be forward thinking and consider the IRD to prevent a large, unexpected penalty from occurring.

When Do You Get Charged The IRD Penalty?

If you have a fixed rate mortgage and you decide to break it before the end of your term you may incur an interest rate differential penalty.

How To Avoid Paying The Interest Rate Differential Penalty

One of the easiest ways to avoid paying the IRD penalty is to use a variable rate mortgage. However considering that fixed rate mortgages are the most common in Canada then you should consider getting your next mortgage from a monoline lenders.

Monoline lenders IRD penalties are significantly less than the big banks, but are only accessible through your local mortgage broker.

3 Pro Tips For Your Next Mortgage:

If you want to minimize or completely avoid paying IRD penalties, and ensure that your next mortgage suits your needs it’s critical that you follow these 3 pro tips:

  1. Start early – researching, talking to your mortgage broker, and getting your finances in order.
  2. Contact your local mortgage broker to get an expert to help you find the best mortgage product.
  3. Interest rate is not the end all and be all! If you’re here reading this article you likely have been surprised with a big fee to break your mortgage. That’s why finding the lowest rate might not always be the best for your situation.
Alex Lavender

Alex Lavender

Alex Lavender is a mortgage broker based out of Halifax, Nova Scotia. He is the author of the book "Mortgages for Millennials" which is used by Canadians to understand how mortgages work. Alex was born raised in a small town in Ontario, and now finds pride in helping everyday Canadians get a mortgage for their first home.

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