Rate Differential: Contractual vs Comparison Rate

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The rate differential is the most controversial variable in the interest rate differential (IRD) calculation. It is defined as the difference between the borrower's contractual rate and the comparison rate used by the lender. The controversy stems from the choice of comparison rate: the Big 5 Canadian banks (RBC, TD, BMO, Scotiabank, CIBC) frequently use their posted rate as the reference, which generally includes a discount not given to the client. This choice artificially reduces the apparent gap and can paradoxically increase or decrease the penalty depending on the method. Monoline lenders and certain Desjardins caisses use the discounted rate instead, which more accurately reflects the lender's actual loss. OSFI has provided clarifications in Guideline B-20 on transparency requirements but has not standardized the comparison rate. In Quebec, borrowers benefit from Civil Code protections, and the AMF-certified mortgage broker must clearly explain how the lender determines this gap. Understanding this nuance can mean the difference between a penalty of a few thousand dollars and one of tens of thousands.

The Rate Gap: At the Heart of the IRD Calculation

The interest rate differential (IRD) relies on a seemingly simple calculation: the difference between your contractual rate and a comparison rate. But behind this simplicity lies one of the most opaque aspects of the Canadian mortgage system: the lender's choice of comparison rate.

Posted Rate vs Discounted Rate

The posted rate is the rate published by the bank on its website and in branches. It is systematically higher than the rate actually offered to clients. For example, a bank may post 6.79% for a 5-year term while offering 4.79% to most clients. The 2% gap between the posted and discounted rates plays a major role in the IRD penalty calculation.

Concrete Impact on the Penalty

Consider a $400,000 balance with 30 months remaining. If the contractual rate is 5.50% and the lender uses a comparison rate of 4.80% (posted rate), the IRD would be (0.055 - 0.048) x $400,000 x 30/12 = $7,000. If the lender used the discounted rate of 3.50%, the IRD would be (0.055 - 0.035) x $400,000 x 30/12 = $20,000. The difference is significant and illustrates why the initial lender choice is so important.

How to Protect Yourself

Ask your AMF-certified mortgage broker to explain each lender's IRD calculation method before signing.
Favour monoline lenders whose calculation methods are more transparent and often more advantageous.
Obtain a written penalty estimate from your current lender before making any refinancing decision.
Check if your contract allows use of the prepayment privilege to reduce the balance before breaking.

Frequently Asked Questions

What is the difference between the posted rate and the discounted rate?

The posted rate is the rate officially published by the bank, generally higher than what clients actually receive. The discounted rate is the rate actually given to the borrower after negotiation. The gap between the two can be 1-2.5%, significantly affecting the IRD calculation.

Why do the big banks use the posted rate in the IRD calculation?

The big banks claim the posted rate reflects their actual cost of funds. In reality, using the posted rate as the comparison rate reduces the apparent gap relative to the client's contractual rate, which can result in higher penalties because the bank compares your rate to an already inflated rate. OSFI has required more transparency but does not prohibit this practice.

How can I verify which comparison rate my lender uses?

Check the prepayment penalty section of your mortgage agreement. The method must be described there. You can also call your lender or ask your AMF-certified mortgage broker to verify. OSFI requires fédéral lenders to disclose this information.

Does the rate differential affect the variable-rate penalty?

No. For a variable rate, the penalty is three months' interest, calculated solely on the balance and current rate. The rate differential does not factor into this calculation. This is a major advantage of variable rates in terms of penalty predictability.

Can I contest the comparison rate used by the bank?

In theory, if the method does not match what is stipulated in your contract, you can dispute it with your institution's complaints office, then with the Ombudsman for Banking Services and Investments (OBSI). In Quebec, the AMF may also intervene if the broker did not adequately inform the client.