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More IRD Info

Professional marketing people know the axiom, "the power of the printed word" as it lends legitimacy to a concept. "It is printed, therefore it must be true!" Be careful what you read. Fortunately, when dealing with mathematics it is easy to verify when someone is wrong.

An article appeared in the November 2002 issue of a well known North American magazine, "Pay Down Your Mortgage Fast". For the most part the article was well written and the journalist was well intentioned. Her treatment of Interest Rate Differentials left a lot to be desired. She was wrong in her analysis and conclusion regarding the IRD or 3 month penalty. The fact that she used the 3 month penalty which is greater than the IRD in this example makes her incorrect conclusion, paying the "penalty" is advantageous, even more ludicrous!

(Screenshot 1)

In plain English, a $100,000 mortgage is being discounted at 8% down to 5% for the next 36 months. Mortgage brokers do this calculation every day. It is not rocket science!

(Screenshot 2)

The Interest Rate Differential, IRD, ("C", a premium in this example) is $7,967.97. A third party person could pay a premium of $107,967.97 for this $100,000 mortgage and would receive 36 monthly payments of $763.21 resulting in a yield a 5% mortgage.

The simple way to view this is IRD example is as follows. After paying the IRD or premium, in order to get the 5% interest rate, the 36 monthly payments of $763.21 will get you to the same point in time and the same balance ($95,655) owing as shown by the two amortization schedules below.

(Screenshot 3)
(Screenshot 4)

One can either purchase a mortgage at a discount in order to get a higher yield or one can purchase a mortgage at a premium (the premium in this example is called the IRD) and therefore get a lower yield. It is worth repeating, .. paying the premium (the IRD in this example) will not save you in interest costs.

In this example, think of it as a fork in the road. You owe $100,000 and have a choice of an 8% path or a 5% path plus a toll. The 8% road costs you nothing to get to the 36 month point and then you owe $95,655.40 where as the 5% road costs you an upfront toll of $7,967.97 and 36 months later you are at the same point as the 8% road and owe the same balance of $95,655. Obviously you are using the same monthly payment in either path. One must always compare identical cash flows in analysis.

The well intentioned author was correct in saying, . most lenders in Canada will charge the greater of the two "penalties", however lenders do make errors and sometimes in the borrowers favour. It is always wise to verify the "penalty" with a professional mortgage broker.

Before making a decision like this one, consult a professional mortgage broker, that is their business!




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