The Private Second and the Prepayment Trap
Marcus, a broker, places a $480,000 first mortgage for clients Ade and Bisi at 6.2%, 5-year term, 25-year amortization, monthly payments. The clients also take a $90,000 private second at 12% interest-only, 1-year term, with a 2% lender fee and a 1% brokerage fee. Combined loan-to-value is 78%. The first mortgage has a three-month interest penalty for early payout in the first year, then a 3-2-1 interest rate differential (IRD) formula for the remainder of the term. Fourteen months later, the clients inherit $120,000 and want to pay out both mortgages. The private second has a 3-month interest penalty plus a $1,500 discharge admin fee. The first lender quotes an IRD penalty of $9,800.
1. Should the clients pay out both mortgages now, or pay out the second and keep the first? Show the reasoning with the numbers given.
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Compare cost of keeping the first against the cost of discharging it. The first is at 6.2%; current comparable rates are not given, so Marcus should obtain a current rate quote to assess the IRD fairly - the IRD is the lender's compensation for lost interest, and a genuine rate comparison is the only way to know whether $9,800 is reasonable or negotiable.
Scenario A - pay both: outflow = $9,800 (first IRD) + 3 months' interest on the second + $1,500. Three months' interest on $90,000 at 12% = $2,700. Total penalty cost ≈ $14,000. They free up the first payment (about $3,150/month at 6.2% over 25 years) and the $900/month second interest.
Scenario B - pay the second only ($90,000 + $2,700 + $1,500 = $94,200), leaving about $25,800 of the inheritance. They keep the first at 6.2%. If current rates are above 6.2%, keeping the first is clearly better and paying the IRD is value-destroying. If current rates are well below 6.2%, the IRD may be cheaper than the interest saved over the remaining term.
Marcus should run a break-even: $9,800 divided by monthly interest saved. If refinancing at a lower rate saved $400/month, break-even is about 24.5 months - longer than many clients stay, and the IRD is paid in cash today. Recommendation: default to paying out the expensive private second first, then decide on the first based on a documented rate comparison, not on the inheritance alone.
2. What disclosure obligations does Marcus have regarding the private second and the fees?
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The private second is a high-rate, short-term, interest-only loan with significant fees - this is exactly the kind of product that requires clear, written disclosure. Marcus must disclose, in writing and before commitment: the 12% interest rate and that it is interest-only (no principal reduction, so the full $90,000 is due at maturity); the 1-year term and the renewal/rollover risk if the first mortgage cannot be refinanced in time; the 2% lender fee ($1,800) and 1% brokerage fee ($900), and who receives each; the 3-month interest penalty and $1,500 discharge fee; and the total cost of borrowing.
He must also explain the risk of the second's maturity: if the clients cannot pay out or renew, the private lender can demand payment, and default remedies on a second can include power of sale. He should confirm the second lender is licensed or exempt as required in Ontario and that the mortgage is registered properly. He must not downplay the fees or present the second as cheap because it is interest-only - the monthly payment understates the true cost. All disclosures should be documented in the file.
3. The clients ask whether they can use the inheritance to pay down the first mortgage instead of discharging it. What should Marcus explain?
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Most closed mortgages allow a prepayment privilege - commonly 10–20% of the original principal per year - without penalty. On $480,000, a 15% privilege would allow $72,000. Marcus should check the actual terms: the privilege amount, whether it is based on original principal or current balance, whether it is calendar-year or anniversary-based, and whether it can be combined with increased payments.
If they prepay within the privilege, they reduce principal and future interest without triggering the $9,800 IRD. If they exceed it, the lender may apply the IRD or a three-month interest penalty to the excess. Marcus should model the interest saved: $72,000 at 6.2% is about $372/month of interest avoided in year one, plus a shorter amortization.
He should also warn that prepaying the first while the 12% second remains outstanding is usually the wrong order - the second costs roughly twice as much per dollar. The rational sequence is: clear the second (highest cost), then apply remaining funds to the first within the prepayment privilege, then reassess whether a refinance at a lower rate justifies the IRD.