*This post was created in collaboration with Mortgage Maestro.
Imagine being free from your mortgage sooner than later and freeing up money that would otherwise be spent on mortgage payments. That’s precisely why many Canadians choose to make early prepayments to their mortgages when possible.
If you’re financially able to, you might want to put extra money available toward your mortgage to pay it down sooner. But while this comes with obvious perks, there are also prepayment penalty fees that you may have to consider before plunking down extra funds toward your home loan.
The question is, will a mortgage prepayment penalty apply in your case? And if so, how much will you be charged?
What Is A Mortgage Prepayment Penalty?
A mortgage prepayment penalty is a fee that your lender may charge you if you:
- Break the terms of the loan contract
- Make higher mortgage payments than your contract permits
- Pay down your mortgage early
Essentially, paying more toward your mortgage or paying the loan off before the end of the term means you’re breaking your mortgage contract (unless there is a clause that says otherwise). In this case, your lender could penalize you with a fee, which can be a hefty sum.
Can You Make Mortgage Prepayment Without Penalty?
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.
Will You Be Charged A Pre-Payment Penalty For Refinancing?
If you make changes to your mortgage contract before the term is up, you will be charged a penalty according to your loan contract. This includes refinancing your mortgage before the end of the term.
There are a couple of ways that this penalty can be calculated:
- 3 months’ worth of interest on your mortgage principal
- Interest Rate Differential (IRD), which equates to the interest lost if the rate on your mortgage is higher than the current posted rate
Where Can You Refinance Your Mortgage?
You can refinance your mortgage with your current lender, or switch to another mortgage lender that offers refinancing.
If you decide to refinance your mortgage, you may be better off using a mortgage broker such as Mortgage Maestro, who will serve as a middleman between you and the lenders within their network.
Each financial institution can only offer you a mortgage and interest rate that’s available within their limited product selection. Instead, a mortgage broker has access to a vast number of lenders — including big banks and B lenders — to find the best mortgage at the lowest rate based on your credit and financial profile.
Rather than meeting with each individual lender on your own, you can speak with a mortgage broker once, who will then approach the lenders they work with to access their mortgage products. This way, your broker is doing all the legwork for you. Not only does this save you a ton of time, but it also ensures that you’re getting the best deal.
Why Do Lenders Charge Prepayment Penalty Fees?
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 early.
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?
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.
Calculating The Cost Of A Prepayment Penalty
As mentioned, your lender will choose the calculation method that ensures a higher prepayment penalty fee.
To help you understand how much you could potentially be charged in prepayment penalty fees, let’s illustrate using an example:
- Loan amount left: $300,000
- Interest rate: 4%
- Mortgage type: Fixed-rate
- Loan term remaining: 24 months
1st Method – 3 Months’ Worth Of Interest
If your lender decides to charge you 3 months’ worth of interest, your prepayment penalty fee would be $3,000. The calculation using this example would be as follows:
$300,000 (outstanding balance) x 4% (current rate) x 3/12 (3 months of interest) = $3,000
|Find your outstanding balance
|Multiply it by the current rate
|4% (4% $300,000 = $12,000)
|Divide the sum by 12 to determine 1 months’ interest
|Multiply the sum by 3 months
|$3,000 (3 x $1,000)
2nd Method – Interest Rate Differential (IRD)
If today’s posted mortgage interest rate is lower than what you’re currently paying, your lender may choose to use the Interest Rate Differential calculation. Assuming the current posted interest rate is 3.25%, your lender would be losing 0.75% (4% – 3.25%) in interest earned on your mortgage. In this case, your prepayment penalty fee would be $4,500 based on the above figures.
|Original mortgage rate
|Minus current mortgage rate
|Interest lender is losing
|Multiple the losing interest by remaining mortgage
|$2,250 ($300,000 x 0.75%)
|Divide the amount by 12 months
|Multiple the amount by the number of months remaining in the mortgage
|$4,500 ($187.5 x 24)
Is The Penalty Rate Different For Variable Rate Mortgages?
For fixed-rate mortgages, either the 3-month interest calculation or the IRD calculation may be used. But for variable-rate mortgages, lenders typically only used the 3-month interest calculation.
The mortgage rate used can vary from one lender to the next. However, the rate is either your current rate or the lender’s prime rate.
How To Get Out Of A Mortgage Without A Prepayment 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.
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.
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.
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.
Ask Your Lender These Mortgage Prepayment Questions
To find out exactly what your repayment penalty fees and privileges are, you must ask your lender some 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?
Mortgage Prepayment Penalty: Bottom Line
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.
Mortgage Prepayment Penalty FAQs
What does breaking my mortgage mean?
Is there any limitation on the prepayment penalty a lender can charge?
How will the stress test affect you?
Note: Loans Canada does not arrange, underwrite or broker mortgages. We are a simple referral service.