When you sign a mortgage contract, you agree to make payments for a certain amount of time. This is called a term, which is typically 5 years (not to be confused with the amortization period). When those 5 years are up you’ll go back to your mortgage lender and agree to another term. When you break your mortgage contract early it means that you want to stop making your agreed-upon regular payments before your term is up.
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 of breaking your mortgage before you sign on the dotted line. Moreover, you should understand the options available to break your mortgage.
Two Options When Breaking Your Mortgage Contract
- Early renewal option: Blend-and-extend
- Break your mortgage contract to change lenders
Early Renewal Option: Blend-and-Extend
The early renewal option: 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 five-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.
The most common way Canadians break their mortgage is by switching lenders. The main reason for the switch is to secure a rate that is lower than 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. Be sure to evaluate the costs involved to see if you’ll actually save on interest.
Costs Of 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, and a reinvestment fee. If you plan on switching lenders may also need to pay 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 different variables. Whether you have a fixed-rate mortgage or a variable-rate mortgage is probably the largest contributor to the penalty you’ll be charged when you break your mortgage contract.
Unfortunately, trying to figure out what you’ll be charged for breaking a mortgage with a fixed rate is very difficult and often leads to homeowners miscalculating the cost of their penalty. This is why we recommend that if you have a fixed-rate mortgage and you need to break your contract for whatever reason you speak with your lender or mortgage broker directly. That being said, your prepayment penalty will be the higher of these two prepayment penalty fee calculations:
- 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. However, it is important to note that interest rates fluctuate; therefore 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.
- 3 Months Interest – As the name explains, this prepayment penalty fee is based on the amount of interest you’d pay in 3-months.
The penalty you’ll be charged for breaking a variable rate mortgage is both significantly lower and easier to calculate. Unlike a fixed-rate mortgage, your penalty fee will always amount to 3-months’ worth of interest. Keep in mind though that all mortgage lenders calculate their penalties with their own equations, so while you can expect to pay 3-month interest, you should also expect some variation in cost.
How You Can Avoid Mortgage Penalties
Mortgage penalties are created to be severe and discouraging to borrowers, but there are strategic ways you can avoid them. This takes planning ahead of signing your mortgage agreement.
Choose An Open Mortgage
An open mortgage is an alternate option to the more traditional closed mortgage. An open mortgage is designed to allow you to break the mortgage term or pay off your owed amount early with no penalty. This flexibility often comes with higher interest rates, and some lenders do not offer open mortgages at all. With proper foresight, if you think you may need to break your mortgage or pay it off sooner than your mortgage term, then it would be wise to opt for an open mortgage.
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 before your mortgage reaches its term’s end. However, if you believe you will 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 are locked in for less time–and once your term ends you can choose to sell without incurring any penalties.
Pay The Maximum Prepayment Possible
While lenders do not want to miss the accrued interest that comes with a mortgage, they often will allow you to pay extra up to a certain annual limit without any consequences. If you are looking to get out of a mortgage, consider taking advantage of your prepayments and paying it off as soon as possible within the agreed-upon limits, if it is within your means.
Porting 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 are not technically breaking it (even if you are moving). This is a great option for those looking to downsize since your mortgage and amount paid-to-date will most likely cover the cost of your new home. If you are looking to move to a larger, more expensive home, then the next option may be best for you.
Having The Buyer Assume Your Mortgage
This is only possible 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. This would transfer your mortgage to the buyer and they would inherit your interest rate, outstanding balance, and term. There are many things 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
- You have the opportunity to secure a lower interest rate which in turn, can lead to thousands of dollars in savings.
- You can change your mortgage terms to better suit your financial situation.
- By securing a lower rate, you may be able to pay off your mortgage earlier if you keep your payments the same (or higher).
- Breaking a mortgage contract early means incurring high fees and prepayment penalties that can offset the savings in interest from a lower interest rate.
- In order to qualify for a new interest rate, you’ll need to undergo the stress test again.
- Those planning on selling their home soon, aren’t likely to benefit from the low-interest savings.
Good Reasons To Break Your Mortgage Contract Early
There are a number of reasons why someone may want to break their contract early. Generally speaking, people usually break their mortgage contacts because:
- They’ve found a lower interest rate with a different mortgage lender
- They need to sell their house
- They want to refinance their mortgage
- Their credit has improved and can now qualify for a better rate or term
- Their finances have changed
Frequently Asked Questions
Can I break my fixed-rate mortgage early?
Is it possible to increase my mortgage (borrow more) without being charged a penalty?
Will I be charged the IRD penalty if I break my variable rate mortgage?
If I want to break my fixed-rate mortgage can I get an IRD penalty quote?
Signing a mortgage contract is often the first and the largest financial decision that an average Canadian will make, understanding fully all of the details and conditions is one of the best steps you can take to assure that no hidden issues pop up later.
Note: Loans Canada does not arrange, underwrite or broker mortgages. We are a simple referral service.