Canada: Mortgage Interest—Pitfalls To Avoid

The following potential pitfalls arising from the federal Interest Act and Criminal Code are avoidable so long as they are taken into account in structuring the transaction.

Annual Rate—Interest Act, Section 4

The first pitfall is interest set at, say, "2% per month". Section 4 requires that wherever any interest is, by a written contract other than a mortgage or hypothec on real property, made payable at a rate per day, week, month or any rate for any period less than a year, no interest beyond 5% per annum is chargeable unless the contract contains an express statement of the yearly rate to which the other rate is equivalent.

Though it may be difficult to express interest at a rate per annum, such as where interest fluctuates with the "180-day London Inter-bank Euro Dollar Offer Rate" ("LIBOR") and interest is based on a 360-day year (similar to U.S. loans), statements setting out the equivalent annual rates can be crafted and should be added.

Blended Payments—Interest Act, Section 6

Section 6 requires that where payments of principal and interest are "blended" (i.e., where a set amount is payable each month with the interest component decreasing as the principal component increases), the mortgage must state the interest chargeable on principal calculated yearly or half-yearly, not in advance. Failure to do so results in no interest at all being chargeable.

As to interest bonuses, the courts traditionally have held that so long as the mortgage on its face does not refer to the bonus, then Section 6 is not triggered.

Floating rates can be a problem under this Section. However, there are various ways to comply, depending on the circumstances, including: setting out in the mortgage the formula on how to compute the equivalent rate, calculated half-yearly, not in advance; adding a schedule setting out the equivalent rate (calculated as required) for a range of given interest rates; provide an amortization schedule setting out the amount of principal and interest for each mortgage payment (together with a provision that the lender may deliver similar, binding, schedules whenever the floating rate changes); or, some combination of these approaches.

As a back-up, it is advisable, in addition to the Section 6 statement, to stipulate that the installments of principal and interest are to be applied first to interest and the balance to principal outstanding and make the payment and calculation period the same (to help assert that the payments are not "blended").

Penalty Interest—Interest Act, Section 8

Section 8 provides (1) No fine, penalty or rate of interest shall be stipulated for … on any arrears of principal or interest secured by mortgage on real property that has the effect of increasing the charge on the arrears beyond the rate of interest payable on principal money not in arrears.

This Section applies to mortgages where, for example, the interest rate is doubled if there is a payment default of principal or interest. This Section is not limited to interest, but includes

fines and penalties, such as a bonus of three months’ interest on default or if enforcement proceedings are taken.

Section 8 can apply, however, in less obvious ways, for example to compound interest: if interest is calculated and compounded half-yearly, do not stipulate for interest after default to be compounded daily.

The more surprising and troublesome problem with Section 8 is with interest-free loans, where the parties, for good business reasons, agree that a loan will be interest-free but if the debtor fails to pay it when due, a reasonable interest rate will then apply. The Ontario courts, however, have struck down such agreements and various attempts to get around the problem, such as by stipulating that interest is waived or reduced if the principal amount is punctually paid when due. Courts in some of the other provinces have taken a less literal view and have allowed such arrangements.

Criminal Code

Section 347 of the Criminal Code (Canada) affects rates of interest chargeable by a lender. It prohibits interest that is more than 60% per year. Although the Section was intended to prevent loan-sharking, the definitions are sufficiently broad to include commercial transactions not usually viewed as criminal loan-sharking. Interest is defined as including the aggregate of all charges and expenses, including a fee, fine, penalty, commission or other similar charge or expense, paid or payable for the advancing of a credit, but does not include such items as insurance charges, overdraft charges or amounts on account of property taxes. A particular problem can arise from fees or late payment charges that are fixed amounts or percentages. For example, a 5% late charge on a utility bill may, if paid within 30 days, contravene the Section.

Problems arising from Section 347 can usually be avoided, or at least minimized, by appropriate drafting of the loan documents and by taking care when demanding payment of a loan.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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