I ran across an article in a Canadian Mortgage Trends blog about an ongoing problem the Canadian mortgage industry has regarding calculating fair mortgage-break penalties, which apply when you need to break your "closed" mortgage contract before the term expires.  The main issue is that the playing field is not always level, often tilted when certain banks distort the calculations in their favour!  

Penalties for breaking a mortgage contract intuitively make sense if you think about the following parallel: Say you are a supplier of widgets, and someone comes to you with a purchase order for 300 widgets over 5 years at a fixed price.  To preserve your profit margin, you decide to simultaneously pre-purchase your supply of widgets from the manufacturer, hence "lock-in" your profit.  Now, if 2 years into the 5 year fixed price contract, the price of widgets has fallen in half and your buyer calls to tell you that they will no longer buy from you for the remaining 3 years, that would really suck. You are still obligated to purchase from the manufacturer at the old price, and the best you can do is sell the surplus on the open market at the new half-price, which is a loss. Since it is not your fault, you send a bill to the buyer for breaking their contract, and the amount of the bill is the difference between what they had agreed to pay you and what you are now selling widgets for on the open market, thus making you even or "whole".  How to calculate the loss fairly is the crux to the IRD or Interest Rate Differential discussion.

Here's the intro to Rob McLister's article...

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Painting a Picture of Penalties

While his point is "lowest rate is not everything", it inspired the rest of my blog about a way to remove discretion from the banks and institute a transparent, industry-wide calculation where game-playing is no more.

My proposal is to use an IRD formula derived solely off Government of Canada bonds using a widely-used technique in other industries called Marked-to-Market.  

For those that don't know, interest rates on many mortgage products are derived or closely co-related to Government of Canada bonds.  So if these bonds go up or down, mortgage rates are soon to follow.

Using a 5-year fixed as an example original term, the "fair" IRD calculation is as follows: (5-year Canada Bond at origination) less (X-year Canada Bond at Early Termination), where X is the closest years remaining, times the loan balance remaining.

The bond data is easy to find*, and the implied assumption is that the premium to bond (gross profit) for any particular lender at the point of origination is acceptable at the point of termination. The other assumption (or agreement required) is that the Government of Canada Bond is acceptable as a proxy funding cost for all lenders.

As an example, if I signed a 5 year fixed at 3.79% and 5 year bond at time was 1.79%, the lender profit or spread was 2% at the time, which we hold constant. If I want to terminate today with 26 months remaining, then the 2-year Canada is used (say 1.03%). So IRD is (1.79%-1.03%) X26/12 yields IRD per term remaining X balance. Notice how 3.79% has nothing to do with the math, nor does the lender's current offering need to be determined. Game-playing is eliminated.

This method is called "mark-to-market" and is the "gold standard" in many other industries, such as Natural Gas Trading. Agreement on the indicy for fair market price* is the only initial debate as I see it. 

In the end, the opportunity for unfavourable "descretion" by the banks is removed, and the system is simple for the guy (or gal) off the street to understand.

*http://www.investing.com/rates-bonds/canada-government-bonds?maturity_from=10&maturity_to=130