If you have a mortgage and decide to end your contract before it comes to term, you'll typically incur a penalty known as a prepayment fee. This fee may apply in several situations:
- Terminating your mortgage agreement early.
- Transferring your loan to another financial institution before the term ends.
- Fully paying off your mortgage by selling your home before the term ends.
These penalties can be substantial, often totalling thousands of dollars. Therefore, it’s essential to understand the circumstances under which these fees apply and how they are calculated. Let’s look into it.
Terminating a mortgage: your type of mortgage pays a pivotal role
When considering terminating a mortgage, it’s essential to note that the penalties for doing so can vary depending on the type of loan you have with your bank.
Open versus closed mortgage
Prepayment penalties are exclusive to closed mortgages. In contrast, with an open mortgage, you can make lump-sum repayments or prepayments at any time without facing penalty fees. However, this flexibility typically comes with higher interest rates compared to closed mortgages.
Fixed versus variable rate
The prepayment penalty imposed by your lender can vary depending on the type of interest rate associated with your mortgage.
With a variable-rate mortgage, the penalty is usually equivalent to three months' worth of interest. On the other hand, for a fixed-rate mortgage, banks may apply either a similar three-month interest penalty or use a more complex calculation method.
How much does it cost to terminate your mortgage agreement?
Terminating a mortgage involves costs set by your financial institution, which can vary among banks. Typically, lenders charge you the greater of the two amounts:
-
An equivalent of three months’ interest on your current mortgage loan.
-
An amount calculated using the Interest Rate Differential (IRD).
In addition to these penalties, your lender may impose additional fees such as administrative and reinvestment fees. Understanding these fees is essential for accurately estimating the total expense of ending your mortgage.
How's the penalty amount calculated?
To calculate the penalty amount for your mortgage loan, your financial institution may consider various factors such as:
- The outstanding balance of your mortgage.
- The remaining term of your mortgage.
- The fixed interest rate specified in your contract.
- The posted rate at the time you initially signed your mortgage.
- The current posted rate.
There are typically two main methods used to calculate the penalty amount:
-
The 3-month interest penalty calculation
The calculation involves multiplying your mortgage balance by the contract interest rate to determine the annual interest. Then, dividing the result by 4 to get the penalty amount.
Mortgage balance x monthly interest = annual interest
Annual interest ÷ 4 = penalty
-
The Interest Rate Differential (IRD) calculation
This calculation method entails subtracting the current posted rate from the rate at signing to find the rate difference. This difference is then multiplied by the mortgage balance and the remaining term duration to determine the penalty amount.
Posted rate at signing – current posted rate = rate difference
Mortgage balance x rate difference x remaining term duration = penalty
Financial institutions typically employ the Interest Rate Differential (IRD) calculation when your current rate exceeds the current posted rate or if you signed your contract within the last 5 years.
Please note that these calculations can vary between lenders and may be influenced by specific terms outlined in your mortgage agreement, which can significantly impact the penalty amount. It's important to review your contract and consult with your lender to understand how these penalties are applied in your situation as it may dissuade you from terminating your mortgage.
Applying the calculation methods: an example
To give you a better idea of what a termination penalty might actually look like, let’s see a concrete example:
Pierre is assessing the penalty he'd have to pay for terminating his mortgage early to benefit from a lower rate. Let’s consider some information.
- His mortgage balance is $250 000 with 3 years remaining at a fixed interest rate of 5%.
- When he originally signed his contract, the posted rate was 6%.
- The current posted rate for a 3-year term stands at 4%.
As explained earlier, Pierre will have to pay the higher penalty between three months of interest or the interest rate differential. Let’s look into it.
The 3-month penalty calculation method
Using the 3-month calculation method, Pierre can estimate his penalty as follows:
250 000$ (mortgage balance) x 5% (monthly interest) = 12 500$ (annual interests)
12 500$ (annual interests) ÷ 4 = 3 1525$ (penalty)
According to this calculation method, Pierre would have to pay approximately $3,125 in penalty fees if he decides to terminate his mortgage early.
The Interest Rate Differential (IRD) calculation method
Using the IRD calculation method, Pierre can estimate his penalty as follows:
6% (posted rate at signing) - 4% (current posted date) = 2% (rate difference)
$250 000 (mortgage balance) x 2% (rate difference) x 3 years (remaining term duration) = $15 000 (penalty)
According to the Interest Rate Differential (IRD) calculation, Pierre would have to pay a penalty of $15 000 for breaking his mortgage early.
Since Pierre must pay the higher amount between the two methods, he would have to pay is $15 000 in penalty fee.
Prepayment privilege: a solution to minimize the costs
To minimize the costs associated with breaking your mortgage contract, you can leverage a strategy known as prepayment privilege. This option, offered by most mortgage lenders, allows you to:
- Increase your regular payments by a specified percentage.
- Make lump sum payments up to a certain limit of the original mortgage amount.
Each financial institution sets specific terms for prepayment privileges, so it's crucial to review your mortgage agreement to determine:
- If you have the ability to make early repayments.
- When these repayments are permissible.
- The minimum or maximum amount you can repay without penalty.
- Any associated fees or conditions.
Before proceeding with any plans to terminate your mortgage, consider using your prepayment privilege if it's available. This approach can potentially reduce your mortgage balance used for penalty calculations, thereby minimizing the overall penalty amount.
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