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Understanding Your Mortgage Penalties

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When you’re house hunting, the last thing on your mind is breaking your mortgage. If you’re like most people who buy a home, you plan to be there for the years to come. Unfortunately, sometimes life happens and you’re forced to break your mortgage. Common reasons include death, divorce, illness and job loss.

A lot of homebuyers are blindsided when they find out how costly it is to break their mortgage. The big banks are notorious for having mortgage penalties that add up to thousands. When you’re forced to break your mortgage, your negotiating position is very weak. You’ll have no choice, but to accept your bank’s costly mortgage penalty.

Why do the Banks Charge You Mortgage Penalties?

When shopping for a mortgage, you have two broad mortgage types to choose from: open and closed. With an open mortgage you’ll pay a higher rate for the ability to pay your mortgage off anytime. With a closed mortgage, you’ll pay a lower rate, but you’re limited by the amount of your mortgage you can pay off. If you pay off more than you’re allowed, you’ll face costly mortgage penalties.

The banks charge you mortgage penalties to recover the money they’re losing. When the banks loan you out a 5-year fixed rate mortgage at 3 percent, they’re expecting to collect interest over those five years. When you want to break your mortgage, the mortgage penalty helps recoup some of that lost interest.

Variable Rate Mortgage

With a prime rate near a record low, a lot of homebuyers are choosing variable rate mortgages. Mortgage penalties with variable rate mortgages are pretty straightforward. You’ll pay a penalty of three months’ interest.

If you’re thinking of breaking your mortgage, you should speak with your bank first to find out if there’s another option. If you’re still determined to break your mortgage, make sure to get an estimate in writing before accepting. If your mortgage is portable, you may be able to sell your old home and “port” it to your new home, thus avoiding costly mortgage penalties.

Fixed Rate Mortgages

Fixed rate mortgages are by far the most popular mortgages in Canada. In fact, the 5-year fixed rate mortgage is the most popular term among homebuyers. If you have a fixed rate mortgage, the mortgage penalty is a bit more complicated. You’ll face a mortgage penalty equal to the greater of three months’ interest and the Interest Rate Differential.

We already spoken about three months’ interest, so let’s take a closer look at the IRD. The IRD is a fancy calculation to determine how much money the bank is losing when you break your mortgage. It uses a comparison rate to determine how costly your penalty will be. Although all banks calculate the IRD the same, the comparison rate used by lenders differs.

The big banks are notorious for costly mortgage penalties. That’s because the comparison rate is the bank’s inflated posted rate. It’s not unheard of for homeowners to face mortgage penalties of $10,000 or more.

Now that you have a better understanding of mortgage penalties be sure to ask about penalties next time you’re shopping for a mortgage. It’s better to find out ahead of time.