This is a common statement generally made by a customer service representative when a mortgagee asks if their mortgage is open or not. There are two types of mortgages – open and closed. An open mortgage is completely open to prepayment at any time.
A closed mortgage is the opposite, but there are two types of closed mortgages. The first is a mortgage that cannot be prepaid at any time. The second allows the borrower early repayment of the loan in full with a penalty. This transpires because when the lender decides to lend money, they do so with the intent of obtaining a specific yield on the mortgage.
Generally, open mortgages are for shorter terms.
In my article “Choosing the Right Mortgage for Your Assets” I made reference to improvement loans. These are typically open mortgages in which the lender expects to get repaid in a short time period. A higher coupon rate on the mortgage is charged, compensating the lender for the risk of payback at any time. The risk of prepayment, if prior to the end of the term, is captured in the interest rate.
Lender still achieves desired yield
This way, the lender still achieves their desired yield on the mortgage while the borrower still has the option to pay out the loan at any time.
For longer term-mortgages, interest rates typically are lower because the mortgage is closed to repayment. In an extreme scenario, the mortgage cannot be prepaid and is fully closed from the start to the end of the term.
The lender will not accept a bonus or prepayment to allow the borrower to pay out the mortgage. The borrower is locked in until the term ends. Once the term ends, the borrower can either pay out the mortgage or enter into a new term. Depending on the type, there are closed mortgages that are closed to prepayment subject to a prepayment penalty.
With these types of mortgages, the lender will accept a bonus or prepayment penalty that allows the borrower to prepay the mortgage in full but also ensures the lender still obtains the desired yield from the mortgage. Prepayment penalties can vary in type with the most common being a three-month interest penalty, interest rate differential penalty and defeasance.
Three months interest is the lowest cost penalty. It is usually calculated using the outstanding balance on the mortgage at the time the prepayment is calculated multiplied by the coupon rate of the mortgage divided by 12 and multiplied by three. Or visually:
Three Months Interest = (Outstanding Balance) x (Mortgage Coupon Rate) x (3/12)
Interest rate differential (IRD) penalty is the most common penalty associated with paying out a mortgage early and is based on a present value calculation. The penalty is determined by two steps.
The first is to present valuing all remaining mortgage payments in the term of the mortgage and the maturity balance using the coupon rate on the mortgage. The second step involves determining a yield in the bond market that has a maturity date that is the same as the mortgage. This yield is then also used in a present value calculation that is applied to all remaining mortgage payments in the term and the maturity balance.
The difference between the two present value calculations is then determined as the penalty. IRD can yield fairly substantial costs and in many cases are not palatable to a borrower.
The last type of prepayment penalty that has been used but is not as common as IRD, is called defeasance. Defeasance is similar to IRD but generally more expensive. There are differences to the present value calculation. However, it is more complex since there are multiple yields associated with the present value calculation. For example, if a mortgage has 20 payments left in the term, then 20 yields are determined for each payment plus a last yield for the balloon payment.
While the calculation may be slightly more accurate, a third-party defeaser actually manages the payout and the administration of each bond when a loan is actually defeased. As a result, it is generally more expensive with more fees associated with any payout of a mortgage.
It is best to fully read and understand your commitment with the lender to ensure you understand your options when entering into a mortgage. Notwithstanding all of the types of penalties, one of the easiest ways to get around a prepayment penalty is to assume the existing mortgage.
Not only is this option cheaper by avoiding the penalty to be incurred, the buyer of a property has the chance to develop a new relationship with a lender.
Darryl Bellwood is a Director of Commercial Lending with First National Financial, Canada’s largest non-bank lender. He is active in most markets in the country with a focus on investment real estate. All feedback is welcome and he can be reached at [email protected].