How Do Lenders Calculate Mortgage Penalities (hypotheque)

By Author: Gregory van Duyse
Total Articles: 9
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How are mortgage penalties calculated?

(Note: This article is part of a series on the topic of mortgage penalties. Your particular mortgage penalty question may be more directly answered in one of the other articles. Please see the list of articles at the end of this one.)

Two ways are used to calculate mortgage penalties that a lender is going to apply to a mortgage. Since there are two ways, the bank will surely choose the one that yields them a higher earnings.

1. Interest times number of months. (2, 3 or 6 months.) First you have to separate the interest payment of the mortgage from the principal portion and multiply it by the number of month's penalty.

Example: If a borrower pays his mortgage after thirty months, for a 25 year mortgage of $200,000 at 5.4%, his monthly disbursements will be $1,209.17 and the interest on the 30th payment will be $846.18. So, if the penalty is 3 months, the calculation of the penalty in this example will be 3 X $846.18 or $2,538.55.

2. The difference between the rates for the rest of the term. (Also know as the rate differential.) This method is a ...
... little complicated but it is used only when the effective rate (when you break your mortgage contract) is lower than the rate that you have negotiated on your mortgage contract. The penalty is equal to the difference of the interest payments between the two rates for the rest of the term. I believe it is easier to understand this with an example.

Example: Let us take the same scenario; you have a $200,000 mortgage amortized over 25 years with a rate of 5.4% for 5 years and a payment of $1,209.17 per month. After 30 months, you have to break your home loan contract (pre-payment) and the bank will impose a penalty. The rate at that moment (30 months later) is 4.75%.

Here is how it is calculated:

a. The lender should have received a certain amount on this loan based on the original rate of 5.4%. Using a financial calculator, the lender determines this amount to be $25, 447.16, which represents the payments from the 30th month through the 60th month, or five years.

b.The amount of interest that that lender can receive now if it lent the money at the rate of 4.75% for the 31 month period (30th payment through 60th payment) is calculated, again using a financial calculator, at $22,250.74.

c. Finally, the bank will calculate the difference between these two numbers, since this represents the loss they will have between the earnings on the old loan and what they will earn on a new loan at current rates. This is a simple calculation: $25,447.16 less $22,250.74 equals $3,196.26, and that represents the penalty the bank will charge to the borrower.

To better understand the penalty:

No borrower wants to pay a penalty on his home loan! That's for sure, but all mortgage loans, apart from some rare types of open mortgages, have penalties for prepayments. The question of penalties includes many aspects which need clear explanation and examples in order to be able to fully understand them.