Mortgage refinancing penalties prompt backlash

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Low interest rates may have made mortgages cheaper. They have also made Douglas Melville a much busier man.

His office, which handles complaints from consumers about their banks, has seen a spike in the number of new cases it is investigating. In the quarter that ended Jan. 31, the Ombudsman for Banking Services and Investments, or OBSI, opened 301 new files - nearly twice the number in the same quarter last year and almost three times as many as in 2008.

Part of the reason for the increase: More consumers are looking into breaking their mortgages to refinance at lower rates - only to discover that doing so often triggers a prepayment penalty of thousands of dollars.

"People were just flabbergasted at the magnitude of the penalties," said Mr. Melville, the head of OBSI, who says his organization has had hundreds of complaints about mortgage penalties. "I ran the numbers myself with my banker for my own mortgage and it was substantial."

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The issue has become so large it has now hit Ottawa's radar. In the March 4 federal budget, Finance Minister Jim Flaherty said he will usher in regulations that will standardize how prepayment penalties are calculated and disclosed.

One frequent complaint is that the method of calculating the penalties is confusing. Last year, as interest rates were falling to all-time lows, Michael Davie looked into breaking the mortgage contract on his two-bedroom Ottawa condominium. The 27-year-old engineer, a first-time homeowner, was just two years into a five-year, fixed-rate mortgage of 4.479 per cent, but he suspected that refinancing might be worth it.

"I decided to have a look at it but I had the same problem as everyone else - I couldn't figure out how the penalty was calculated," he said.

He searched his mortgage documents and failed to find it spelled out anywhere. A quick call to the mortgage company revealed that his penalty was the so-called interest rate differential, or IRD. Mr. Davie was charged a $2,500 penalty for breaking his mortgage and refinancing at a lower variable rate, saving himself roughly $300 a month in interest payments.

Still, he would have preferred it if the penalty had been clearly explained in the paperwork. "It says what goes into it, but it does not give you the math of how to do it. It would have been great if I could have figured it out myself."

While mortgage lenders are disclosing the fees, "what we've been seeing is that it's not written in a very clear and simple way," said Jean-François Vinet, an analyst at Option consommateurs, a non-profit consumer rights group. "It's really hard for consumers to get it."

In most of the cases it's investigated so far, OBSI has found the bank's disclosure was clear and the customer did not suffer any loss.

"At the moment, we have about a dozen case files still open where some form of compensation is likely to result," Mr. Melville said. "We believe compensation is warranted due to a lack of clear disclosure by the firm of the prepayment penalty calculation."

On a variable-rate mortgage, a penalty of three months' interest is usually charged for prepayment. For fixed mortgages, the penalty could be three months or the IRD, which is more difficult to calculate. The IRD is based on the difference between the existing mortgage rate and the one at which the customer would be renewing.

Sometimes lenders calculate it using the posted mortgage rate - increasing the size of the penalty - rather than using the lower, discounted rate that many customers actually pay.

Over the years, most people had grown accustomed to the fees being three months interest, Mr. Melville said. "It just happens that in this unique interest rate environment, that was not the case. It was the three months' interest or the IRD, and right now the IRDs are a lot bigger than the three months' interest."

The Canadian Bankers Association says that banks have clear disclosure practices "that set out specifically what is required when consumers want to prepay their mortgages."

In most instances, Mr. Melville agrees.

"Getting into a mortgage is the single largest financial transaction you will do in your life; don't take it lightly," he said. "Get help if you don't understand it yourself. It's a small price to pay to get the right advice when you're signing up for a very large financial commitment over the next 15, 20, 25 years."