Breaking A Canadian Mortgage Contract

*This post was created in collaboration with Alpine Credits

When you sign a mortgage contract, you agree to make payments until the end of your term. But you may also choose to break your mortgage contract early, which means you’ll stop making your agreed-upon regular payments before your term is up. However, there is often a penalty for breaking a mortgage early, so you’ll need to find out what type of fees may come with ending your term before its official due date.

Key Points

• Breaking your mortgage early often comes with prepayment penalty fees.
• The penalty for breaking a mortgage contract before the end of the term is usually the greater of 3 months of interest, or the interest rate differential (IRD).
• You’ll need to make sure your loan contract allows you to break your mortgage early before exercising this option.

Breaking Your Mortgage Contract

While most people don’t think about breaking their mortgages before they even have one, it’s still very important that you understand the consequences before you sign on the dotted line. Moreover, you should understand the options available to break your mortgage:

• Early renewal option through a blend-and-extend
• Break your mortgage contract to change lenders

Early Renewal Option: Blend-and-Extend

The early renewal option, or the “blend-and-extend”, involves extending the length of your mortgage before the end of your term. This option allows you to blend your old interest with your new one so that you come up with a rate that is somewhere between your current and the new mortgage rate. 

This option is often better than switching lenders as you’re able to avoid the prepayment penalty fees. This is due to the fact that you aren’t completely breaking your mortgage contract with your lender.  

For example, let’s say you have 3 years left on a 5-year, fixed-rate term. Your current interest rate is 5% but your lender is willing to offer you 3% now.  

Instead of refinancing your mortgage with the 3% interest rate, you’ll get a new blended interest rate that ranges between 5% and 3%. As for your term, it would be extended back to 5 years.

Switching Lenders

The most common way Canadians break their mortgage is by switching lenders. The main reason for the switch is to secure a lower rate compared to what they currently have. 

Breaking your contract to switch lenders means you’ll be able to renegotiate your mortgage for a lower rate and terms that better suit your financial situation. 

However, by breaking your contract early, you’ll be subject to hefty fees and penalties. You’ll also need to undergo the mortgage stress test again, so you’ll need to make sure you can qualify at a higher rate than your contract rate. Be sure to evaluate the costs involved to see if you’ll actually save on interest.

Penalty For Breaking Your Mortgage Contract

When you break a mortgage contract, you’re required to pay your lender a pre-payment penalty as well as other fees such as: 

• An administration fee
• An appraisal fee
• A reinvestment fee
• A fee to register your current mortgage to a new one

In terms of the prepayment penalty, the amount you’ll have to pay depends on a few factors, including the following:

• The amount you want to pay off early
• The number of months left on your mortgage term
• The interest rate on your mortgage
• Whether you have a fixed-rate mortgage or a variable-rate mortgage

How To Calculate Early Prepayment Penalty Calculation

Your prepayment penalty will be the higher of these two prepayment penalty fee calculations: 

3 Months Interest 

As the name explains, this prepayment penalty fee is based on the amount of interest you’d pay in 3-months. This is the method used to calculate the penalty for breaking a variable-rate mortgage.

Interest Rate Differential (IRD) 

The IRD compensates your lender for the interest they are losing out on because you’re breaking your mortgage early. This is calculated by finding the difference between the amount of interest you’d be paying on your current term for both rates. This is the method typically used on fixed-rate mortgages.

However, it’s important to note that interest rates fluctuate. As such, the interest rate you were given when you signed your mortgage contract may not be the same as the interest rate your lender could charge now.

There are two ways that lenders may calculate your penalty fee using the IRD calculation method:

Posted Rate Calculation

Banks and some credit unions often use the posted rate calculation method, which typically results in a bigger penalty. As the name implies, this calculation uses the Bank of Canada’s posted rate. 

For instance, let’s say you took out a mortgage two years ago when the central bank’s posted rate was 4.49%. Now, you’re looking to break your mortgage early before your term is up. If you have a 5-year term, you’d have 3 years left on it. 

Now let’s say the current posted rate for a 3-year term is 3.95%. In this case, the difference between the original posted rate and today’s posted rate is 0.54%. 

Since you still had 3 years remaining on your loan term, your lender would multiply 0.54% by 3, which would result in a penalty rate of 1.62%. So, you’d have to pay a penalty fee of 1.62% of your remaining mortgage balance. If you had a balance of $400,000 left on your mortgage, the penalty would work out to $6,480.

Published Rate Calculation

Instead of using the Bank of Canada posted rate, the published rate calculation method uses published rates. Generally speaking, alternative lenders often use this method. 

For example, let’s say you have 3 years left on a 5-year term. Your current mortgage rate is 3.95% and the current published rate is 3.69%. Your lender would subtract the published rate from your current rate, which would result in 0.26%. Then, you’d multiply that by 3, since you have 3 years left on your term, which would give you 0.78%.

Using the same $400,000 mortgage as above, your penalty fee would work out to $3,120.

If the IRD penalty is higher than 3 months’ worth of interest, many lenders would go with the IRD calculation, as it’s the greater of the two.

How You Can Avoid Mortgage Penalties 

Mortgage penalties exist to discourage borrowers from breaking their mortgages before the term is due. That said, there are strategic ways you can avoid them: 

Choose An Open Mortgage

An open mortgage is an alternate option to the more traditional closed mortgage. With an open mortgage, you can pay off your loan early without penalty. This flexibility often comes with higher interest rates, though not all lenders offer open mortgages. 

Select A Shorter Term

Most homebuyers prefer to take long-term mortgages to reduce their monthly payments and make the mortgage more manageable. This is a good option if you do not plan on selling your home before the end of the term.

However, if you think you’ll need to sell or upsize your home soon, then a short-term mortgage may be the best choice for you. A short-term mortgage means you’re locked in for less time; once your term ends, you can choose to sell without incurring any penalties. 

Pay The Maximum Prepayment Possible 

While lenders don’t want to miss the accrued interest that comes with a mortgage, they may allow you to make an extra payment up to a certain annual limit without any consequences. 

Port Your Mortgage

If you are looking to move to a bigger home, porting your mortgage can be a great way to avoid penalty fees. Porting your mortgage allows you to take your existing mortgage term, interest rate, due amount, and end date with you to your new home. Since your mortgage remains unchanged, you’re not technically breaking it, even if you’re moving. 

This is a great option if you’re looking to downsize, especially if your mortgage is enough to cover the cost of your new home. But if you’re looking to move to a larger, more expensive home, then the next option may be better for you. 

Have The Buyer Assume Your Mortgage

If you’re selling your home, see if it’s possible to have the buyer take over the existing home loan. This can only happen if your lender is willing to let the new buyer assume your mortgage, which is within their discretion, and dependent on the buyer’s financial situation. 

When a buyer assumes a mortgage, the existing home loan is transferred to them. The buyer would inherit your interest rate, outstanding balance, and term. 

There are many factors at play that most often make this less than ideal for the lender, but it is an option worth investigating to avoid penalization. 

Pros And Cons Of Breaking A Mortgage Contract Early

Before deciding whether to break your mortgage early, take some time to weigh the advantages and disadvantages to determine if it’s worth it.

Pros

• Snag a lower rate. If you have the opportunity to secure a lower interest rate, you could potentially save quite a bit of money in interest over the life of the loan. However, you’ll need to do the math to see if the potential savings outweigh the penalties you would have to pay.
• Modify your loan terms. You can change your mortgage terms to better suit your financial situation.
• Pay off your loan sooner. By securing a lower rate, you may be able to pay off your mortgage earlier if you keep your payments the same (or higher).

Cons

• Penalty fees. The biggest drawback to breaking a mortgage contract early is the financial penalty. You could potentially incur high fees and prepayment penalties that can offset the savings in interest from a lower interest rate.
• Stress test may be required. To qualify for a new interest rate, you’ll need to undergo the stress test again, particularly if your lender is federally regulated.

Good Reasons To Break Your Mortgage Contract Early

There are a handful of scenarios in which breaking your mortgage contract early might make sense:

• You’ve found a lower interest rate with a different mortgage lender
• You want to sell your house
• You want to refinance your mortgage
• Your credit has improved and can now qualify for a better rate or term
• Your finances have changed

Regardless, it’s still important to crunch the numbers and find out what the penalty fee will be before breaking your mortgage. This way, you can determine if it’s worth it to do so. 

Additional Reading

Features You Want To See In Your Mortgage Contract In 2024

Porting A Mortgage | What Does It Mean?

Mortgage Broker Vs Bank: Who Should You Work With?

Bottom Line

Getting out of your mortgage before the term ends is a process that can come with financial repercussions if you don’t time it right. Make sure you understand the penalty for breaking a mortgage in Canada and all the details involved before you choose to end your mortgage before the term is up.

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Note: Loans Canada does not arrange, underwrite or broker mortgages. We are a simple referral service.