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A mortgage is a hefty financial commitment to repay a large sum of money to a lender to buy a home. Considering this, the thought of paying all the money that you owe before it’s actually due might be far from your thoughts when you initially take out a mortgage.

But there are a few factors that you should consider when you take out a mortgage, and early repayment is one of them. In fact, you can actually be penalized for paying off your mortgage sooner than the initial due date. This might sound strange to you now, but when you consider the money that lenders might stand to lose in interest if you repay your mortgage early, it makes sense.

So, what is a mortgage prepayment penalty, and why is it charged?

What is a Mortgage Prepayment Penalty?

An early mortgage prepayment penalty is charged to borrowers who pay off their mortgages before the loan’s maturity date. While your goal might be to get rid of the big debt and even save a lot of money that would otherwise have been paid in interest, you could still wind up dishing out quite a bit of money after paying these prepayment penalty fees.

Trying to consolidate high interest debt into your mortgage? Read this first.

But why do lenders charge these fees? The reason is simple: to recoup any lost money that would have otherwise earned in interest. Mortgage lenders are in the business to make money, and letting a borrower off early is counterproductive to business. As such, they charge penalty fees to borrowers who pay their mortgages off early.  

Cost of Buying a House in Canada
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How Do Lenders Calculate Mortgage Prepayment Penalties?

Now you understand why lenders charge these fees, but how much do they charge? How do they come up with these prepayment penalty fees?

Basically, there are two ways that lenders calculate mortgage prepayment penalties, though they’ll vary from one mortgage lender to the next.

The prepayment penalty fee will usually be the higher of one of the following:

1. Three months’ interest on the amount still owed on the mortgage.

2. The interest rate differential (IRD) – This refers to the difference between your current interest rate on your home loan term and the interest rate for a mortgage term of the same length of time as that which remains on your current loan term.

Your mortgage contract will stipulate how your lender will calculate the prepayment penalty on your mortgage. It’s important that you fully understand exactly how your prepayment penalty fees will be calculated and how much will be charged if you ever pay off your mortgage before the end of the term.

Want to know the difference between a mortgage term and a mortgage amortization? Find out here.

How to Get Out of a Mortgage Without a Penalty?

Not all mortgage products require borrowers to pay a penalty for prepaying their mortgage early. Your obligation to pay such penalty fees depends on the type of mortgage you carry. More specifically, an open versus a closed mortgage will determine whether or not you’ll be subject to prepayment penalties.

Open mortgages – These types of home loans allow you to prepay your mortgage whenever you like without having to pay any compensation charges. The trade-off for such flexibility is that the interest rates are typically a little higher than closed mortgages. That said, you should be able to switch over to a fixed-rate mortgage if you are no longer comfortable with variable interest rates.

Click here for a closer look at fixed and variable rate loans.

Closed mortgages – These mortgage products come with a prepayment limit, which means you’re only allowed to pay a certain amount of the original principal amount of the mortgage every year. If you pay more than that stipulated amount in one year, you’ll have to pay a prepayment penalty fee.

But while closed mortgages are stricter than open mortgages in terms of when and how much you choose to pay off your mortgage, their interest rates are usually lower than open mortgages. Further, you may be able to make a certain number of accelerated payments, though every lender will have its own prepayment terms.

Want to learn more about your mortgage payment options? Be sure to read this.

At the end of the day, however, having a closed mortgage basically means that you promise to stick around until the stipulated end date of the mortgage term. If you pay off the loan before that date, you’ll be subject to repayment penalty charges.

Is Mortgage Prepayment Ever Allowed?

There may be times when you can put a little extra toward your mortgage principal without incurring prepayment penalty fees. A “prepayment privilege” refers to the amount of money that you’re allowed to put toward your closed mortgage in addition to your regular mortgage payments without paying any prepayment penalties.

While every lender may have their own specific rules governing prepayment privileges, they usually allow borrowers to increase their regular payment by a specific percentage or make one large payment up to a certain amount. Your mortgage contract will stipulate exactly how you’re able to take advantage of any prepayment privileges that may exist.

Need a down payment for your house? Check this out.  

Ask Your Lender These Mortgage Prepayment Questions

In order to find out exactly what your repayment penalty fees and privileges are, it’s important that you ask your lender a number of important questions, including the following:

  • Are there are any prepayment privileges?
  • What is the amount that can be prepaid without incurring any charges?
  • Do any fees exist for making early prepayments?
  • What is the maximum prepayment amount?
  • How often can prepayments be made?
  • When can prepayments be made?
  • Do any conditions exist to early prepayments?

Look here to see the minimum credit score for mortgage approval.

Know Before You Prepay

Like any other contract, it’s important that you understand all of the terms and conditions of your mortgage contract before you take one out. If you have intentions of making early prepayments at any point throughout your mortgage term, you’ll want to know if any prepayment penalties exist.

When it’s time for you to shop around for a mortgage, let Loans Canada help. We can connect you with a mortgage specialist who can offer you a mortgage that is best suited for you.

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

Lisa Rennie avatar on Loans Canada
Lisa Rennie

Lisa has been working as a personal finance writer for more than a decade, creating unique content that helps to educate Canadian consumers in the realms of real estate, mortgages, investing and financial health. For years, she held her real estate license in Toronto, Ontario before giving it up to pursue writing within this realm and related niches. Lisa is very serious about smart money management and helping others do the same.

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