This article has been updated from a previous version.
In today’s changing mortgage landscape, many Canadians may be contemplating breaking their mortgage terms due to the recent decline in interest rates. Those who renewed or secured mortgages during a period of rising rates may find this an opportune moment to refinance and lock in more favorable terms.
There are other reasons why someone may look to break their mortgage, as well, like needing money for renovations, family expansion, moving for work, or helping your kids pay for university.
However, 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 a borrower breaks 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 two options:
- Three months of interest
This involves paying the equivalent of three months' worth of interest on your remaining mortgage balance. - Interest rate differential (IRD)
The IRD is calculated based on the difference between your current mortgage rate and the lender's current rate for a term matching the remaining period of your mortgage, applied to your remaining balance.
Lenders may use either the posted interest rate or a discounted interest rate to determine the IRD. Big banks often 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.
Read more: Beware, as mortgage rates drop, the pre-penalties don’t
| 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 |
| 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 greater 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 the alternatives to breaking your mortgage?
Here are three strategies to potentially save you money:
Port your mortgage
If you’re moving, you should consider taking your mortgage with you to avoid the penalty. This is called “porting” your mortgage. However, there’s a caveat. You can usually only port your mortgage if you’re buying a new home and selling your old one at the same time. Be prepared to re-qualify for the ported mortgage by proving your creditworthiness again.
Make extra payments
If you anticipate breaking your mortgage early, you can make extra payments to reduce the balance on which the penalty is calculated. Many mortgages allow you to prepay up to a certain percentage of the principal in one lump sum.
Negotiate penalties
Try to negotiate lower penalties if you’re refinancing your mortgage with the same lender. There’s no guarantee, but generally, mortgage rates and terms are always negotiable.
Related: What is a straight switch?
Are there any 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:
Appraisal fees: An appraisal is often required to assess the current market value of your property. This ensures that the lender has up-to-date information about their investment's worth, and these fees typically range from a few hundred dollars to over a thousand, depending on the complexity of the valuation.
Legal and registration fees: Legal fees cover the cost of having a lawyer manage the necessary documentation and ensure the transaction complies with regulations. Registration fees might also apply when officially recording the new mortgage agreement.
Title insurance: This insurance protects both the lender and the borrower against potential disputes over property ownership. It is a one-time fee and is often mandatory in refinancing situations.
Discharge fees: When you pay off your original mortgage, the lender may charge a discharge fee to cover the administrative costs of closing out the mortgage account.
Reinvestment fees: Some lenders charge a reinvestment fee, which compensates them for the interest they would have earned had the loan remained until maturity.
You will also be required to complete a new application, credit check, and employment verification. If you’re considering breaking your mortgage, whether that’s for a better interest rate or for family or personal reasons, use the mortgage payment and mortgage affordability calculator. It’ll display a quick estimate of your penalty so you can make an informed decision.
Read next: The benefits and pitfalls of mortgage prepayments
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.
