What the heck is an IRD and how will it impact me?
The IRD or Interest Rate Differential is a charge levied by lenders that may apply if you pay off your mortgage before it matures. Or if you pay more on the principal beyond the amount of your prepayment privilege. It other words, it’s a prepayment penalty.
What’s important for you to know is how the IRD is calculated. First of all, the IRD is based on:
- The amount you are pre-paying; and,
- An interest rate that equals the difference between your original mortgage interest rate and the interest rate that the lender can charge today when re-lending the funds for the remaining term of the mortgage.
Mortgage Penalties Explained
Prepayment penalties are common on “closed” mortgages. “Closed” mortgage interest rates are usually lower than “Open” rates. There are no penalties on “Open” mortgages. On variable-rate mortgages the penalty is often three months interest.
On fixed-rate mortgages, the penalty is the greater of three months interest or the Interest Rate Differential (IRD).
Here’s how the IRD comes into play. You promised to pay a specific interest rate, let’s say 3.5%, for a set number
of years, let’s say five years. If you decide to break that arrangement after three years, whether you’re refinancing or purchasing a new home, the lender gets the remaining money back to relend. To match the original term, the lender wants to get the same interest rate or more on the remaining two years.
This penalty can be high to you if interest rates are falling. In that scenario, if you paid out the mortgage early, the lender needs to put the money back on the street as “shorter term” money, matching the remaining term. Shorter money is usually at a lower interest rate than longer term money.
So, a lender will calculate how much less interest they will receive over the remaining term at the lower earning rate, which is also called the “reinvestment” rate, compared to your promise of 3.5%.
Difference between banks and monoline lenders -- it’s in the calculation!
Most non-bank lenders calculate the difference between your original rate and the current rate for the remaining term – “discounted to discounted”.
Banks calculate differently. If the original rate was really 4.29% (their posted rate) but they did you a favour and only charged you 3.5%, the IRD would be calculated between 4.29% and the reinvestment rate, (how much less interest they will receive over the remaining term at the lower earning rate) which increases the IRD amount – “posted to discounted”.
Penalties can only be quoted “as of today”.
The penalty changes with the following:
• Passing an anniversary date
• Mortgage balance
• Interest rate changes
• Remaining time to maturity
The penalty is not penalized until there is a formal payout statement requested by you, based on a firm payout date. Bottom line for bank calculations: If interest rates fall, IRD penalties increase.