The calculation of mortgage penalties
(Note: This article is part of a group on the topic of mortgage penalties. Your particular mortgage penalty question may be more readily answered in one of the other articles. Please see the list of articles at the end of this one.)
Home loan lenders use two methods to calculate the penalty and, since there is more than one way, you can be sure they will use the method that yields a higher amount for them
1. Number of months interest penalty (2, 3 or 6 months). You have to separate the interest piece of your mortgage payment from the principal and then multiply it by the number of months designated for the penalty.
Example: With a 25 year, $200,000 mortgage at 5.4%, if it is paid off after 30 months, the monthly payments are $1,209.17 and the interest portion on the 30th month is $846.18. Using a 3 month penalty, that number is multiplied by three to come up with the total penalty-$846.18 X 3 = $2,538.55.
2. The rate difference for the balance of the term of the loan. Also known as the rate differential.) This is a bit more complicated to calculate, but it is used when the current rate (in force when you break your contract) is lower than the rate you got when you negotiated the contract. In this case, the penalty is figured to represent the differential between the two mortgage interest totals over the rest of the term. An example will explain it better:
Example: If we have the same mortgage, $200,000 25 year amortized 5 year mortgage with a rate of 5.4%, the monthly mortgage payment is $1,209.17. If the homeowner breaks the contract after 30 months by prepaying the loan, the lender will charge a penalty because he can now only lend at the current interest rate, which, 30 months after the old loan, is now at 4.75%.
Here is the calculation:
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 today 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.The differential between the interest payments received by the lender is $25,447.16 less $22,250.74 or $3,196.26. There is your penalty!
How can we better understand this penalty system?
No borrower thinks it is fair to have to pay a penalty on his mortgage, of course. But, except for some specialized mortgages, all mortgages have penalties for pre-payment. It is a very involved subject, and it requires careful explanation and example in order to make it clear.
