Mortgage Prepayment Penalties Explained

Mortgage prepayment penalties: three months' interest vs the IRD

A closed mortgage is a promise to keep your loan with the lender, at the agreed rate, for the whole term. Break that promise early (by selling, refinancing, switching lenders mid-term or paying down more than your privileges allow) and you will usually owe a prepayment penalty. The penalty can be modest or it can run well into five figures, and which one you face depends on a calculation that is easy to overlook until you need it. Here are the questions worth asking, answered in order.

What is a prepayment penalty, and when does it apply?

A prepayment penalty is what a lender charges when you pay off more of a closed mortgage than your contract allows before the term ends. That includes breaking the mortgage to sell the home, refinancing to borrow more or get a different rate, switching lenders mid-term, or making a lump-sum payment beyond your annual prepayment privileges.

Two situations usually don't trigger one. An open mortgage has no prepayment penalty. And at the end of your term, you can renew with another lender or pay off the balance without a prepayment penalty, though switching can involve other costs such as discharge, registration or appraisal fees.

How is three months' interest worked out?

It is roughly what it sounds like: three months of interest on the balance you are prepaying, at your contract rate. On $200,000 at 4.00%, three months' interest is $2,000.

In this example the IRD is small, $400, because the contract rate of 4.00% is close to the comparison rate of 3.80% and only 12 months are left. The penalty is the larger of the two, so here it is $2,000: three months' interest.

Worked exampleWhen three months' interest is larger

Balance: $200,000
Contract rate: 4.00%
Comparison rate: 3.80%
Months left: 12
Three months' interest: $2,000
Simplified IRD: $400
Likely penalty (larger): $2,000
Method: three months' interest

Assumptions: Illustrative: $200,000 balance, 4% contract rate, 12 months left, and a comparison rate of 3.8%; simplified interest rate differential. Computed by the site's calculators.

How does the interest rate differential work?

The IRD is meant to cover the interest the lender loses if it has to relend your money at today's lower rate for the rest of your term. In its simplest form it is the difference between your rate and a comparison rate, applied to your balance for the time remaining.

The Financial Consumer Agency of Canada uses this example. You owe $200,000 at 6.00% with 36 months left, and the lender's current posted rate for a 36-month term is 4.00%. Three months' interest would be $3,000. The IRD is $12,000. The lender charges the higher amount, so the penalty is $12,000.

Worked exampleFCAC's illustration: when the IRD is larger

Balance: $200,000
Contract rate: 6.00%
Comparison rate: 4.00%
Months left: 36
Three months' interest: $3,000
Simplified IRD: $12,000
Likely penalty (larger): $12,000
Method: the interest rate differential

Assumptions: The Financial Consumer Agency of Canada's example: $200,000 balance, 6% contract rate, 36 months left, and a lender's current posted rate of 4% for a 36-month term. Computed by the site's calculators.

Which rate does the lender compare against?

This is the single most important detail in the calculation, and it differs between lenders. The comparison rate is a rate for a term close to the time left on your mortgage, and many lenders use posted rates rather than discounted rates in the calculation. Because the methods differ, two lenders can produce quite different penalties for the same balance, rate and time remaining.

Lenders must tell you how they calculate the penalty, and your prepayment privileges and penalty terms appear in an information box at the start of the mortgage agreement. Before you break a mortgage, ask for a written penalty figure for a specific date. For background on posted rates, see posted vs discounted mortgage rates.

Can I reduce or avoid the penalty?

Sometimes. The options depend on your contract and your timing.

Use your prepayment privileges first. Paying down the balance within your annual allowance before you break can shrink the amount the penalty is calculated on.
Wait for the end of the term. If your plans can wait until renewal, you can switch lenders or pay off the mortgage without a prepayment penalty.
Check the five-year rule on long terms. For an individual's mortgage with a term longer than five years, the Interest Act lets you repay after five years with three months' further interest.
Ask about alternatives. Porting the mortgage to a new home, or a blend and extend, may avoid breaking the contract outright. Ask how each would be priced.
Count cash back. If you received cash back when you signed, you may also have to repay it.

How do I check my own number?

The estimator's IRD is a simplified version. Your lender's own method may give a different figure, so treat the lender's written number as the one that counts.

Find the prepayment information box at the start of your mortgage agreement.
Ask your lender for a written penalty figure for the date you plan to pay off or switch, and which method and comparison rate it used.
Compare that figure with the prepayment penalty estimator, which shows both three months' interest and a simplified IRD.
If you are breaking to get a lower rate, set the penalty against the interest saved with the renewal switch calculator.
Grade any new offer in the fixed mortgage checker so you know whether the new rate is worth the cost of leaving.

Questions people ask

Will I pay a prepayment penalty if I switch lenders at renewal?

No prepayment penalty applies at the end of your term. You may face other switching costs, such as discharge, registration, transfer or appraisal fees, and you can ask the new lender whether it will cover some or all of them. See switching lenders at renewal.

Is the penalty on a variable-rate mortgage calculated the same way?

Your agreement sets out the method for your specific mortgage, so check the information box or ask your lender. The general rule for closed mortgages is the higher of three months' interest or the IRD, but which one applies depends on your contract and how your rate compares with current rates.

Do I have to repay cash back if I break my mortgage?

You may have to. Check your agreement for the cash back conditions and ask your lender to include any repayment in its written penalty figure.

Is the calculator's IRD what I will actually pay?

Not necessarily. It uses a simplified formula: balance, times the difference between your rate and a comparison rate, times the years remaining. Lenders each use their own method and comparison rate, so the lender's written figure is the one to rely on.

What does the Interest Act say about long mortgage terms?

For an individual's mortgage with a term longer than five years, section 10 of the Interest Act lets the borrower repay after five years with three months' further interest. Before five years, the penalty terms in your contract apply.