One of the few good things about the COVID pandemic is lowered mortgage interest rate for our home owners and real estate investor clients. However, most of those are in the form of variable interest rate, meaning that it’s dependent on prime rate routinely set by Bank of Canada. While a 1.95% mortgage rate looks amazing now, what happens if it increases to 3.45%, even during your mortgage term of 5 years? Today, Sabrina, founding lawyer of Varity Law, will guide our readers through the crucial differences between popular mortgage structures, and offer some behind-the-scenes info on subtle changes happening when mortgage is being registered at law offices.
Variable vs. Fixed Interest Rates
Fixed interest rate means that during its term (e.g. 5 years), the interest rate will remain unchanged. So if Katie has a fixed rate of 2.82%, it will be 2.82% for 5 years, regardless of fluctuations in prime rate.
In contrast, if Joe has a variable interest rate of prime – 0.5%, and if prime rate today is 2.45%, then Joe’s interest rate would be 1.95%, which looks a lot better than Katie’s 2.82%. But what if in a year or two, after the economy recovers from COVID, Bank of Canada raises prime to 3.95%? (from March 2018 to March 2020, 3.95% was the prime rate). Then, Joe is stuck with 3.45% until his terms ends. In contrast, while Katie does not benefit from the low prime rate now, equally she would not suffer from a possible higher prime rate in the future. So in terms of predictability and planning, fixed rate may be better.
“Penalties” are not always 3 months interests
Naturally, many of our clients want to switch from fixed to variable interest in today’s market. And when prime raises, they would want to go back to the low fixed rate. However, if this is done during the mortgage’s term, there will be “penalties” involved. (I put penalties in semi-colons because Courts are more resilient to enforce penalties vs. damages, and banks will say those charges constitute their damages – but colloquially we talk about those charges as penalties).
When doing your calculations to see if it’s worth it to break a mortgage during its term, keep in mind that penalties are not always 3 months interest. Usually, banks have 2 ways of calculating penalties – a complicated way based mainly on the amount of term left, and a simple way being just 3 months interest on the principal outstanding. In general, the more time you have left on your term, the more expensive the penalties are – so if Terry has 4 years left for a 5 years term, and Sue has 1 year left for a 5 years term, Terry will likely be paying a lot more penalties –$20k to $30k of penalties are common.
Banks will always choose the calculation method that result in higher penalties. So if there is very little time left on the term, they will likely use the 3 months interests method, and vice versa. In the end, it might not be worth it to breach the mortgage to switch to another lender with more favourable interest rate.
Registered Mortgage and Agreement Mortgage
If the mortgage is a collateral mortgage, then the registered terms and the agreement terms (the mortgage agreement that the home owners signed with the banks) are often different. Usually, the registered mortgage would be for the entire value/purchase price of the house – such as $1 million – but the amount funded or given to the home owners are only $600k. Why would this be? This is one way to encourage home owners to come to the same bank for future loans instead of going to a different one. When a new lender sees that the entire value of the property is already mortgaged out, they are unlikely to advance a new loan.
As well, the registered interest rate may be 7% whereas the interest rate in the signed agreement is only 2%. This is often done to help protect banks against default – so if you do not pay your mortgage for a while, the banks have the right to remedy their losses through charging a higher interest rate.
Lastly, registered mortgage may say “in demand” – which often give banks the right to require you to pay all of the principal outstanding immediately (instead of paying in monthly installments), usually after long periods of missed payments. This usually happens when the home owners have defaulted for so long that the banks decided to essentially cancel the mortgage and get their principal back immediately.
Conclusion
Therefore, although the variable mortgage interest rate is very low right now, it is not without its risks. Home owners and real estate investors should be mindful of interest rate differences, penalty calculations, and the details of registered mortgages when considering financing options. We welcome you to call 905-597-9357 for an initial free consultation.
The information above is meant to offer general legal information. For specific legal advice applicable to your particular situation, we invite you to book a consultation with us.
