Mortgage penalty for breaking your contract

Do you have a mortgage? If you want to get out of your contract before it expires, you'll usually have to pay a penalty.

Early termination fees, also called prepayment penalties, may be charged by your lender when you:

• You cancel your mortgage agreement;
• You transfer your loan to another financial institution before the end of the term;
• You make additional payments over what is allowed;
• You sell your home before the end of the term and pay off your mortgage in full.

The penalties charged by your bank can be expensive, sometimes running into thousands of dollars. That's why it's important to understand when they apply and how they're calculated.

Ending a mortgage

Before we get to the heart of the matter, it's worth noting that mortgage foreclosure penalties vary depending on the type of loan you have with your bank.

Open vs. closed loans

Prepayment penalties only apply to closed mortgages.

With an open mortgage, you can make lump-sum or prepayments at any time without penalty. However, this greater freedom comes at a higher interest rate than a closed mortgage. 

Fixed vs. variable rate

You should also be aware that the compensation you pay to your lender may vary depending on the type of rate you contract.

In the case of a variable or adjustable-rate mortgage, the penalty is usually equal to three months' interest. For a fixed-rate mortgage, banks may also charge you this three-month penalty or use a more complicated calculation.

What is the penalty for terminating a mortgage?

The fees you'll be charged for cancelling your mortgage are determined by your lender. They may vary from bank to bank.

In most cases, lenders will charge you the higher of the following two amounts:

• An amount equal to 3 months of interest on your current mortgage;
• An amount determined by the interest rate differential (IRD).

In addition to the calculated penalties, your lender may also charge you other amounts, such as administrative fees and reinvestment fees. It's important to take these into account when determining the total cost to you of terminating your mortgage.

Be sure to read your contract for all applicable terms and conditions.

How to calculate the penalty on a mortgage loan?

To determine the penalty you must pay, your lender will take into account:

• Your mortgage balance;
• The time remaining on the term;
• The fixed interest rate on your contract;
• The posted rate at the time the mortgage was signed;
• The current posted rate.

For the 3-month penalty, the following calculations are performed:

Mortgage balance x Contract rate = Annual interest

3 months x Annual interest ÷ 12 = Penalty

The IRD will be calculated as follows:

Posted rate at the time you signed - Current posted rate = Rate difference

Mortgage balance x Rate difference x Remaining term = Penalty

Check the interest rate used here. The lender doesn't necessarily use the rate you're paying, but the posted rate. This can have a big impact on the penalty you pay. It could also be a deterrent if you were planning to terminate your mortgage just to take advantage of a rate reduction. 

Financial institutions usually use the IRD calculation if your mortgage rate is higher than the current rate, or if you signed your contract within the last 5 years.

Be aware that the way the IRD is calculated may vary from lender to lender. Federally regulated banks offer online calculators to give you a rough idea of what you'll have to pay.

Calculation example

To help you better understand what the penalty might be for terminating your current mortgage, let's look at a more concrete example:

Peter wants to know what penalty he will have to pay to break his mortgage contract and take advantage of a better rate. 

His mortgage balance is $250,000 and his contract expires in 3 years. The interest rate is fixed at 5%.

When he signed his mortgage, the posted rate was 6%. At the time of closing, the posted rate for a 3-year term is 4%.

Peter must pay the higher of the two penalties explained above: 3 months of interest or the interest rate differential.

3-month penalty

Peter can calculate his penalty as follows:

250 000 $ x 5 % = 12 500 $

3 months x $12,500 ÷ 12 = $3,125

Using this method, Peter would pay approximately $3,125 in penalties. 

Penalty calculated with IRD

6 % - 5 % = 2 %

250,000 x 2% x 3 years = $15,000

Using the IRD calculation, Peter would pay $15,000 in penalties.

Since the amount obtained using this method is the higher of the two, Peter will be charged the higher amount. Therefore, the idea of cancelling his mortgage to change his interest rate seems unattractive.

How can prepayment privileges reduce your costs?

Mortgage-breaking penalties can be a significant amount of money. To limit the amount you have to pay, here's a tip you can take advantage of.

Mortgage lenders typically offer borrowers the option to pay off a certain amount on top of their regular payments without penalty. This is called a prepayment privilege. This may allow you to:

• Increase your payments by a percentage;
• Pay a lump sum, up to a certain limit of the original mortgage.

The privileges granted may vary from one financial institution to another. Check your mortgage contract to find out:

• Whether you are entitled to make prepayments;
• When you can do so;
• The minimum or maximum amount allowed;
• Fees and other conditions that apply.

So before you take any steps to end your mortgage, it may be worthwhile to take advantage of your prepayment privilege if you can. By doing so, you could reduce the balance of your mortgage used in the calculation, as well as the applicable penalty.  

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