The bank is giving me a big discount off their posted rate. I must be getting a great rate!?

Unfortunately, it’s not that simple. The short answer is you won't know that you received a great rate unless you've shopped your mortgage to numerous lenders. The long answer involves learning what the major banks' posted rate is really all about.

With a couple of minor exceptions, ONLY the major banks have posted rates. The major banks' posted rate is found on a rate sheet and the posted rate has no meaning whatsoever at the time you’re taking your mortgage. The only time the posted rate comes into play is when you break your mortgage before the end of the term resulting in a prepayment penalty. The prepayment penalty is calculated based on what the posted rate was on the day you took out your mortgage.

Bank salespeople are trained to making it seem like you are getting a great mortgage rate by drawing your attention to the discount you are receiving off their posted rate. You may be surprised to learn that every customer that qualifies at the bank, receives the same discount off the posted rate (some may receive a small additional discount reserved for certain situations) and that no one actually receives a mortgage at the posted rate! Regardless of the discount received, banks calculate prepayment penalties by using the rate difference between your contract rate and the posted rate on the day you took your mortgage, and subtracting that rate difference from the posted rate that is closest to your remaining term.

For example, suppose on the day you took out your mortgage, the posted 5-year fixed rate was 6% and you received a contract rate of 4% - a discount of 2%. Three years later (2 years remaining on your mortgage term), you need to break your mortgage and the 2-year posted rate at that time is 4.5%. The bank will subtract the full discount you received of 2% from the 2-year posted rate: 4.5% - 2% = 2.5% (confused yet?).

Next, the bank will compare your contract rate with the rate just calculated: 4% - 2.5% = 1.5%. This 1.5% calculated is referred to as the Interest Rate Differential or IRD. The IRD is the rate the bank uses to calculate your prepayment penalty. Always ask the bank salesperson to explain their IRD calculation to you and if your fixed rate mortgage penalty will be based on posted rates, market rates, bond yields, or discounted rates.

It is important to note that every time mortgage rates fall, it is favourable to NEW mortgage borrowers but unfavourable to existing fixed-rate mortgage holders due to higher prepayment penalties. It is also worth noting that non-bank lenders (e.g. Monoline Lenders) do NOT use posted rates and, generally, their IRD is based on the contract rates both on the day you took your mortgage as well as the day you are breaking your mortgage. Unless there are just a couple of months remaining in the mortgage term, the difference in IRD between the major banks and non-banks can be substantial, usually several thousands of dollars!