The calculation of mortgage penalties
(Note: This is only one article of a series on the subject of mortgage penalties. If you have a specific question regarding them, perhaps it may be better answered in one of the others, so please refer to the list at the end of this article.)
Home loan lenders use two ways to calculate the penalty and, since there is more than one way, you can be sure they will use the way that yields a higher amount for them
1. A certain number of months of interest payments (2, 3 and even 6 months). You have to split the interest component of the mortgage payment and multiply it by the number of months 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 amount is multiplied by three to come up with the total penalty-$846.18 X 3 = $2,538.55.
2. The difference between the rates for the rest of the term. (Also know as the rate differential.) This calculation 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. It may be easier to understand this with an example.
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 borrower 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 amount of interest that the bank should have received on the mortgage from the 30th payment until the 60th payment (5 years) is 5.4%. Using a financial calculator, the lender can calculate that the interest would be $$25,447.16.
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 corresponds to 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.
Borrowers have some difficulty understanding this 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 complicated subject, and it requires careful explanation and example in order to make it clear.