Paying off your mortgage before the end of its term can seem like a good idea, whether you're looking to secure a better interest rate or adjust your finances to a new situation. However, this decision may lead to significant costs.
Most financial institutions charge penalty fees for early repayment, commonly referred to as prepayment charges. These fees may apply if you transfer your mortgage to another lender, sell your home before the term ends, or make unauthorized extra payments on your loan.
The amount owed can reach several thousand dollars. That’s why it’s essential to understand the rules surrounding these fees, the types of loans affected, how the penalties are calculated, and what strategies can help reduce the financial impact.
Breaking a mortgage: the basics
Before deciding to break your mortgage contract, you need to know that the penalties depend directly on the terms set out in your agreement. Two main factors influence the fees you might have to pay: the type of mortgage (open or closed) and the type of interest rate (fixed or variable).
Open versus closed mortgages
Prepayment penalties apply only to closed mortgages. If you’ve chosen an open mortgage, you can make additional payments or pay off your loan in full at any time without facing a penalty.
However, open mortgages usually come with a higher interest rate compared to closed ones. On the other hand, a closed mortgage offers a lower rate but includes strict repayment restrictions.
Fixed rate versus variable rate
The interest rate structure in your contract, whether fixed or variable, also plays a major role in determining your penalty amount. In many cases, breaking a fixed-rate mortgage will result in higher fees than breaking a variable-rate loan.
Selling your home or transferring your mortgage: how much will the penalty cost?
The penalty charged by your lender for breaking a mortgage contract depends on several factors and can vary significantly from one financial institution to another. Generally, the lender will charge whichever of the following two amounts is higher:
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The equivalent of three months’ interest on your current mortgage balance
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An amount calculated based on the interest rate differential (IRD)
But that’s not all. Additional fees may also be added on top of the main penalty, including:
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Administrative fees
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Reinvestment fees
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Any specific indemnities outlined in your contract
To avoid unpleasant surprises, it is crucial to carefully read the terms of your mortgage agreement. The exact conditions for termination, how penalties are calculated, and related charges will all be detailed in the document.
How is a mortgage penalty calculated?
To determine the penalty amount you may owe for ending your mortgage before the end of its term, your lender will consider a number of factors, including:
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Your remaining mortgage balance
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The time left in the term
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Whether your interest rate is fixed or variable
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The posted rate at the time you signed the contract
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The current posted rate at the time of termination
Depending on your situation, one of two methods will be used:
1. Three months’ interest
This method calculates the annual interest on your remaining mortgage balance and divides it by four, representing a three-month period.
Mortgage balance × interest rate ÷ 4 = penalty
This formula is commonly used for variable-rate mortgages, but it may also apply to some fixed-rate mortgages if it results in a higher penalty than the IRD.
2. Interest rate differential (IRD)
In this method, the lender calculates the difference between the interest rate stated in your contract and the current posted rate for a comparable term. That difference is then applied to your mortgage balance over the remaining time left in the term.
(Contract rate – current rate) × mortgage balance × time remaining = penalty
This method is typically used for fixed-rate mortgages, especially when current interest rates are lower than the rate in your original contract.
Example of how mortgage penalties are calculated
To better illustrate how mortgage penalties work, let’s look at a concrete example. Pierre wants to break his mortgage contract before the end of the term to take advantage of a lower interest rate. Here are the details of his loan:
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Mortgage balance: $250,000
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Time remaining on the term: 3 years
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Fixed interest rate: 5%
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Posted rate at the time of signing: 6%
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Current posted rate for a comparable 3-year term: 4%
Pierre will be required to pay the higher of two amounts: three months’ interest or the interest rate differential (IRD).
1. Three months’ interest
Formula: Mortgage balance × interest rate ÷ 4 = penalty
$250,000 × 5% ($12,500) ÷ 4 = $3,125
According to this method, Pierre would pay approximately $3,125 in penalty fees.
2. Interest rate differential (IRD)
Formula: (Contract rate – current rate) × mortgage balance × time remaining = penalty
6% – 4% (2%) × $250,000 × 3 years = $15,000
In this case, the IRD-based penalty is higher. Pierre would therefore have to pay $15,000 if he breaks his mortgage contract.
This example highlights that while a lower interest rate may seem appealing at first, prepayment charges can offset, or even outweigh, the potential savings. It’s always important to do the math before making a decision.
How to reduce prepayment charges using your prepayment privileges
Mortgage penalty fees can represent a significant financial burden. However, there is a simple and effective strategy that may help reduce the cost: using your prepayment privileges.
Most lenders allow borrowers to repay a portion of their loan in addition to regular payments, without incurring a penalty. These options, usually outlined in your mortgage agreement, typically take two main forms:
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Increasing your regular payment amount, up to a certain percentage set by the lender
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Making a lump-sum payment, generally limited to an annual percentage of the original loan amount (for example, 10% or 15% per year)
By using these privileges before breaking your mortgage, you may reduce the remaining balance used to calculate the penalty, and therefore lower the amount you have to pay.
Since these conditions vary from one lender to another, it’s important to check your mortgage agreement to find out:
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Whether you are allowed to make prepayments.
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When these prepayments can be made (some lenders require a specific date during the year).
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What the maximum annual prepayment amount is without penalty.
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Whether any fees or restrictions apply to the use of this option.
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