According to mortgage industry experts, more than half of Canadians break or renegotiate their mortgage before maturity. The reasons vary and include: finding better interest rates, needing money for renovations, family expansion, moving for work, or kids going off to university.
If you choose to break a closed mortgage before the end of your term, you will pay a penalty. So, when does it make sense to end your mortgage early, and how does the process work?
How are mortgage penalties assessed?
Mortgage penalties are intended to compensate lenders for the money they’ll lose when you break a mortgage contract early. Most mortgages can be broken, including fixed and variable rate mortgages. Variable-rate mortgage penalties are generally equal to three months’ interest on your loan. The penalty for breaking a fixed-rate mortgage, on the other hand, can be significantly higher, sometimes so much so that it may not make financial sense to break the mortgage early simply to refinance. Fixed-rate mortgage penalties are generally the greater of:
A) three months of interest, or
B) the interest rate differential (IRD).
Lenders can use the posted interest rate or a discounted interest rate to determine the IRD. Big banks use posted rates which can cause significantly higher penalties for some fixed-rate mortgages. Here’s an example. Assume you have a five-year fixed-rate mortgage with two years left on your term and an initial mortgage rate of 4.26%. Here’s how many lenders would calculate your penalty.
Calculating three months’ interest on your loan
|Current mortgage principal||$500,000|
|Original mortgage rate||4.26%|
|Multiply your original mortgage principal by your original mortgage rate||$500,000 x 4.26% = $21,300|
|Divide the amount you get by four||$21,300 / 4 = $5,325|
|Your three-month interest penalty||$5,325|
Calculating your mortgage penalty using the IRD
|Current mortgage principal||$500,000|
|Current lender’s name||Your current lender|
|Original mortgage rate||4.25%|
|Remaining term||24 months (two years)|
|Find your current lender’s mortgage rate for an equal term to your remaining term||Assume your current lender’s two-year fixed rate is 3.74%|
|Subtract the current rate from the original rate||4.26% – 3.74% = 0.52%|
|Multiply your principal by the difference in interest rates||$500,000 x 0.52% = $2,600|
|Divide that amount by 12 months||$2,600 / 12 months = $216.67|
|Multiply the monthly fee by your remaining term||$216.67 x 24 months remaining = $5,200|
|Your IRD penalty||$5,200|
In this scenario, you would pay a penalty of three months’ interest on your loan because it’s smaller than the IRD. As mentioned, major banks use IRD formulas that can be far more punitive for borrowers, which might result in double the IRD penalty you see here.
What are alternatives to breaking your mortgage?
Here are three ideas to save you money:
- If you move, you can generally take your mortgage with you and avoid the penalty. This is also called “porting” your mortgage. You can usually only port if you’re buying a new home and selling your old one at the same time. And you must re-qualify for the ported mortgage by proving your creditworthiness again.
- If you foresee breaking your mortgage during its term, you can make extra payments to reduce the balance on which the penalty is calculated. Most mortgages allow you to prepay a set percentage of the principle in one lump sum.
- Try to negotiate lower penalties if you’re refinancing your mortgage with the same lender. There’s no guarantee, but mortgage rates and terms are always negotiable.
Is there additional costs related to breaking a mortgage?
Unfortunately, yes. When you break a mortgage, you will take out a new mortgage, also referred to as refinancing. Refinancing a mortgage entails additional fees, which can include: You also complete a new application, credit check and employment verification. If you’re considering breaking your mortgage, whether for a better interest rate or for family or personal reasons, use a mortgage penalty calculator. It’ll display a quick estimate of your penalty so you can make an informed decision.
- Appraisal fees
- Legal and registration fees
- Title insurance
- Discharge fees
- Reinvestment fees