This article has been updated from a previous version.
Are you thinking about switching your mortgage to snag a lower interest rate?
If so, you're not alone. It’s a tale as old as time: an unsuspecting homeowner decides to break their current mortgage in favour of another lender at a lower rate, only to be whacked with a monster prepayment penalty.
Breaking a fixed-rate mortgage can easily run into five figures. As we’ve written before, the mortgage penalty could be as much as $15,000, as it was for homeowner, Jill Groves, or even $30,000, as it was for Ontario resident, Kristina Barybina.
With the Bank of Canada cutting rates after a period of record highs, many locked in higher rates could now benefit from lower ones. Before making any changes, let's explore what you need to know to avoid surprises when breaking a fixed-rate mortgage, so you’re not caught by surprise when the paperwork is drawn.
The double-edged sword of tumbling rates
Most borrowers cheer for lower mortgage rates, especially new homebuyers and those whose mortgages are nearing renewal.
But if you’re an existing Canadian homeowner stuck in a fixed mortgage, falling posted rates can actually increase the penalty you’ll face when breaking your mortgage.
This is especially true if your lender advertises inflated posted rates and uses those ‘artificial’ rates to calculate prepayment penalties.
The bigger the IRD, the higher the penalty
And before you ask – yes, the penalty applies to mortgages from all of Canada’s largest banks.
This is because a fixed-rate mortgage holder wanting to break their mortgage would likely face an interest rate differential (IRD) penalty during a period of declining rates.
IRDs should be based on the difference between your contract rate and the rate your lender could charge new borrowers today for a term equivalent to the remaining time of your mortgage (a.k.a., the “comparison rate”).
However, many large lenders use calculation methods that artificially widen this rate gap (i.e., increase the interest rate differential). The net effect could be a massive increase in prepayment fees.
Moreover, as fixed rates fall, the comparison rate also decreases, widening the IRD and hiking up your penalties. And that can happen quickly.
Read more: What affects variable and fixed rate Canadian mortgage rates?
Your lender may adjust the penalty based on a shorter-term rate
Another critical factor that drastically changes penalties is the comparison term.
If the time remaining on your mortgage shifts closer to a shorter term, say from three years to two, your lender may adjust your penalty based on the shorter-term rate, further increasing the IRD and consequently, the cost.
This is because they re-lend your funds based on a 2-year fixed term instead of a 3-year fixed term.
How to avoid punitive mortgage penalties
One way to ensure you won’t have to pay a costly prepayment penalty is to consider a variable-rate mortgage, known for its flexibility.
The penalty for breaking most floating rate mortgages is just three months’ interest which can be significantly less than the penalties associated with fixed-rate mortgages.
However, variable rates aren’t for everyone, especially with many of today’s most competitive mortgage rates being for fixed terms.
If you prefer a fixed-rate mortgage but want to minimize prepayment risks, look for a ‘fair penalty' lender. These lenders charge reasonable (i.e., “fair”) penalties to prepay the mortgage. In many cases, that works out to just three months’ interest instead of the dreaded IRD.
Although these fair-penalty options may come with slightly higher rates (e.g., 0.1%-points), as a rule of thumb the extra cost is very often worth it if there’s a better than 1-in-3 chance you’ll break your mortgage early.
People break their mortgage early for all kinds of reasons, such as refinancing to lower their rate, accessing equity for renovations, or selling and renting and so on their property.
Paying 1/10th of a percentage point more now may be a lot better than paying a $10,000+ exit fee later.
It's a surprise no one wants, especially when you're trying to save money in the long run.
Read next: The final mortgage payment: What you need to know
Compare Mortgage Rates
Engaging a mortgage broker before renewing can help you make a better decision. Mortgage brokers are an excellent source of information for deals specific to your area, contract terms, and their services require no out-of-pocket fees if you are well qualified.
Here at RATESDOTCA, we compare rates from the best Canadian mortgage brokers, major banks and dozens of smaller competitors.
