Over the past few years, the Financial Consumer Agency of Canada's (FCAC's) Compliance and Enforcement Branch (CEB) has observed a significant increase in the number of complaints it has received related to mortgage prepayment penalties. Specifically, consumer complaints have primarily focused on the interest rate differential (IRD)1 option that appears in many mortgage agreements.
Mortgage prepayment penalty disclosure has always been an important issue for FCAC. In 2002, CEB undertook a high-level industry review to assess the extent to which mortgage prepayment penalty calculation components were present in disclosure documents sampled from seven federally regulated financial institutions (FRFIs).
Following the review, all FRFIs were instructed to review the prepayment clauses in their disclosure documents to ensure compliance with the regulations.
The increase in the number of complaints received by FCAC regarding mortgage prepayment penalties seems to indicate a broader spectrum of issues with all types of financial institutions.
Legislation sets out that a FRFI that enters into a credit agreement for a loan shall disclose to all borrowers:
In addition, FRFIs are required to provide a description of any components that comprise a formula to calculate a penalty in the event that the borrower exercises the right to repay the amount borrowed before the maturity of the loan.3
Furthermore, this information must be made in language and presented in a manner that is clear, simple and not misleading.4
If a credit agreement for a loan secured by a mortgage is to be renewed on a specified date, the institution must, at least 21 days before the date, provide the borrower with a subsequent disclosure statement that contains the information required to be disclosed by Section 8 or Section 9 of the Cost of Borrowing Regulations (the Regulations).5
Since the mortgage prepayment penalty review, and in light of many consumers looking to switch or refinance mortgages due to record low interest rates, FCAC has seen a marked increase in complaints from consumers about mortgage prepayment penalty calculations based on IRD. These complaints have led us to identify additional concerns not addressed in the mortgage prepayment penalty review in 2002.
The complaints received generally highlight three issues:
The regulations require specific disclosure of information consumers need to make sound decisions regarding their financial products and services.
For mortgage prepayment penalties, the requirements to provide the manner in which the penalty is calculated and a description of all the components of the calculation, all presented in clear and simple language, are meant to allow consumers to understand how the mortgage prepayment penalty is arrived at, and to allow them to calculate what the mortgage prepayment penalty might be. With this information, consumers may assess whether mortgage prepayment is right for them in their financial situation.
Failure to provide all the information required, or failure to provide this information in a complete, clear and usable manner, hinder consumers' ability to decide on mortgage prepayment and do not meet the letter nor the intent of the law.
Given the number and scope of the issues we have recently identified regarding mortgage prepayment penalties, we believe that additional clarity for FRFIs is required to help ensure that disclosure is compliant with the regulations and ultimately meets the needs of consumers.
The Commissioner of FCAC expects FRFIs to provide consumers with mortgage prepayment penalty disclosure that would allow them to understand and calculate the penalty amount. This would ensure that consumers have the information they require to make informed decisions regarding this significant financial commitment.
In light of this interpretation, FRFIs are expected to incorporate the following into their mortgage prepayment disclosure documents6:
The components to be disclosed should be the variables that make up the formula used by the FRFI to calculate the mortgage prepayment penalty.
For example, if a FRFI uses a present value calculation to calculate the penalty, the components should include variables such as: future value, payment, effective annual rate, number of payments remaining and outstanding balance.
The description of the components should provide the borrower with an understanding of what each component is and the key characteristics of each of those components.
The description need not include a fulsome description of the calculation(s) used to arrive at the actual value for each of the components.
The description of the components should include information to allow consumers to understand how they can obtain the value of each of the components disclosed. This may be achieved in the following ways:
FRFIs must demonstrate that they have applied the principles of clear language to their mortgage prepayment penalty disclosure. FCAC's Clear Language and Presentation Principles and Guidelines for the Industry can be found at http://www.fcac-acfc.gc.ca/eng/industry/commissioner/guidance/cg-3/index-eng.asp.
In addition, in order to meet the principles of clear and simple language, FRFIs should also:
Many FRFIs use mortgage prepayment penalty calculations that are complex and may not be easily presented in a manner that is clear and simple, and therefore are not user-friendly for the average consumer (e.g. a present value calculation).
In such cases, in addition to the disclosure referred to in elements #1 and #2, the disclosure documentation must also include a simplified method (e.g. estimated IRD) through which the borrower can calculate a reasonable estimate of the prepayment penalty.
The inclusion of a simplified calculation should meet the following disclosure criteria:
1. IRD is a charge that may apply if you pay off your mortgage prior to the maturity date, or pay the mortgage principal down beyond the amount of your prepayment privileges.
2. The Bank Act, 452(1)(a)(ii) and 570(1)(a)(ii); The Trust and Loan Companies Act, 438(1)(a)(ii); The Cooperative Credit Associations Act, 385.18(1)(a)(ii); and The Insurance Companies Act, 482(1)(a)(ii) and 601(1)(a)(ii)
3. Cost of Borrowing Regulations, 8(1)(l)
4. Cost of Borrowing Regulations, 6(4)
5. Cost of Borrowing Regulations, 14(1)
6. Initial mortgage disclosure statements and mortgage renewal disclosure statements
7. The disclosure should be brief and concise to allow consumers to understand the manner in which the penalty is calculated.