Canuck Mortgages 101
Recent transactions involving U.S. lenders advancing on the security of Canadian real estate have reminded this author that, even in this era of unprecedented cultural assimilation with the United States, there remain some very fundamental differences between the two countries when it comes to real estate law generally, and mortgage lending laws in particular. Although the volume and size of the trans-border mortgage financings have abated of late (indeed the volume and size of all financing has abated of late in the shadow of the current “credit crunch”), one can only expect to see the differences between U.S. and Canadian lending laws becoming a significant deal point in future mortgage loans once the credit spigot is turned back on.
One glaring example of these irreconcilable differences in the legal framework for mortgage lending can be seen in the American practice of charging a “default” interest rate that is separate and apart from the “regular” (i.e. non-default) interest rate. So, a typical American mortgage loan that charges X per cent per annum while the borrower is not in default, will automatically increase by 300 (or more) basis points if the borrower is in default. While this additional rate of interest might otherwise be “fair” in a commercial sense, since borrowers in default require far greater monitoring and other administrative costs on the part of the lender than borrowers not in default, what most American lenders (and, frankly, many Canadian lenders who take their precedents and underwriting guidelines from United States head offices) simply do not realize is that the practice of charging a higher rate of interest on mortgages after a default is strictly illegal in Canada.
The whole of Canada (including the province of Quebec) is governed by the provisions of the Interest Act, a very protective piece of Depression-era federal legislation which had, at its original purpose, the role of taking some of the sting out of the mortgage contracts of the day that were causing ballooning foreclosure rates in the 1930s. The modern version of Section 8 of the Interest Act expressly states:
No fine, penalty or rate of interest shall be stipulated for, taken, reserved or exacted on any arrears of principal or interest secured by mortgage on real property that has the effect of increasing the [interest rate] charge on the arrears beyond the rate of interest payable on principal not in arrears.
This provision, which is unique to Canada, explains why most Canadian mortgage loans expressly provide that the interest rate is the same both before and after default.
Section 8 of the Interest Act also has a less apparent, but equally dramatic impact on “prepayment premiums,” “yield maintenance clauses,” “defeasance payments” and similar breakage costs associated with the early prepayment of closed mortgages. Although the terms and formulae vary from mortgage to mortgage, the right to prepay a closed mortgage on payment of a “prepayment premium” is common to almost all U.S. mortgages (and an ever-increasing number of Canadian commercial mortgage loans). Typically, such prepayment premiums are calculated as the difference between: (a) the present value of the scheduled payments, calculated using the interest rate in the mortgage as a discount rate; and (b) the present value of the scheduled payments, calculated using the interest rate payable under a Government of Canada treasury bond of approximately the same term as the discount rate. This form of “treasuries flat” calculation (so called because there is no additional amount added to the treasury yield before discounting) ostensibly compensates the lender for the financial loss resulting from the early payment.
It is not that Section 8 of the Interest Act makes such prepayment premiums illegal per se. They are perfectly legal and are ordinarily binding upon the borrower, so long as the borrower is not in default under the mortgage. Instead, what Section 8 of the Interest Act does is to prevent a lender from collecting the prepayment premium whenever the lender is threatening to foreclose the mortgaged property. Canadian courts have routinely interpreted Section 8 as prohibiting the enforcement of prepayment premiums upon a default under the mortgage. Instead, in Canada, where a lender is enforcing under a defaulted mortgage, the borrower is entitled, as a matter of law, to repay the then outstanding principal, all arrears of interest, interest on such arrears, and enforcement costs incurred by the lender, but nothing else and certainly nothing like a prepayment premium. In short, if a Canadian mortgage is put into default, and the lender is proceeding with foreclosure as a remedy, then the borrower can, in effect, redeem at par without regard to any prepayment premium.
The case law regarding the enforceability of prepayment premiums in Canada is extensive and there are a number of exceptions to the general rule. So, for instance, a number of Ontario cases suggest that a prepayment penalty of up to three months interest may be permissible in Ontario notwithstanding Section 8 of the Interest Act.
Furthermore, there are also some suggestions that a Canadian court would, notwithstanding Section 8 of the Interest Act, permit lenders to enforce prepayment premiums upon a default where it looks as if the borrower deliberately acted in bad faith to goad the lender into accelerating the loan and enforcing the security. Cases along these lines are scarce but, it stands to reason that borrowers ought not be able to use Section 8 of the Interest Act as a means to get out of long-term closed mortgages by deliberately stopping payments under a mortgage until a lender has no choice but to take recourse against the collateral.
However, where the borrower can be shown to have made every reasonable effort to negotiate in good faith with the lender, and is not threatening to withhold payments under the mortgage just in order to force the lender’s hand, then there is no credible argument why a borrower could not rely on Section 8 of the Interest Act to redeem at par if the lender then still elects to put the mortgage into default for one or more breached covenants. In contrast, a lender that blatantly advertises to the world that it has the right to declare a default under the mortgage with the intent of forcing a windfall prepayment premium, and then systematically refuses to negotiate in good faith with its borrower over the alleged default, will likely find itself on courtroom steps with little sympathy from a Canadian judge reading Section 8 of the Interest Act.
While U.S. lenders are progressively viewing Canada as a viable new market that, good, bad or ugly, behaves largely like the U.S. market, differences in mortgage lending laws, like Section 8 of the Interest Act, will continue to remind U.S. lenders that Canada is not just the 51st state and that there are legal differences to contend with in financing the Great White North.
Jeffrey W. Lem, B.Comm. (U of T), LL.B. (Osgoode), LL.M. (Osgoode), practises in the areas of commercial real estate and finance with the law firm of Davies Ward Phillips & Vineberg LLP, and has been called to the bar in Ontario, England and Wales. He is an executive member of the Real Property Section of the Ontario Bar Association and is editor-in-chief of the Real Property Reports, published by Carswell Thomson Professional Publishing.
This article provides general information only and is not intended to provide specific legal advice. Readers should not act or rely on information in this article without seeking specific legal advice on their particular fact situations.