Mortgage fees: Prepayment penalties

From: Financial Consumer Agency of Canada

What is a prepayment penalty

A prepayment penalty is a fee that your mortgage lender may charge if you:

  • pay more than the allowed additional amount toward your mortgage
  • break your mortgage contract
  • transfer your mortgage to another lender before the end of your term
  • pay back your entire mortgage before the end of your term, including when you sell your home

Your lender may also call the prepayment penalty a prepayment charge or breakage cost.

Prepayment penalties can cost thousands of dollars. It’s important to know when they apply and how your lender calculates them.

If you have an open mortgage, you can make a prepayment or lump-sum payment without paying a penalty.

What is a prepayment privilege

A prepayment privilege is the amount you can put toward your mortgage on top of your regular payments, without having to pay a prepayment penalty.

Your prepayment privileges allow you to:

  • increase your regular payments by a certain percentage
  • make lump-sum payments up to a certain amount or percentage of the original mortgage amount

Prepayment privileges vary from lender to lender.

Check the terms and conditions of your mortgage contract to find out:

  • if your lender allows you to make prepayments
  • when your lender allows you to make prepayments
  • if there's a minimum or a maximum amount that you’re allowed to prepay
  • what fees or penalties apply
  • if there are other conditions

Most lenders limit the allowed prepayment amount per year. Typically, you can’t carry a prepayment amount from one year to the next. This means you usually can’t add the amount you didn’t use in previous years to the current year.

How much prepayment penalties can cost

The way your prepayment penalty is calculated varies from lender to lender. Federally regulated financial institutions, like banks, have a prepayment penalty calculator on their website. You can visit your bank’s website to get an estimate of your cost.

Your cost depends on factors such as:

  • the amount you want to prepay (or pay off early)
  • the number of months left until the end of your term
  • interest rates
  • the method your lender uses to calculate the fee

The prepayment penalty will usually be the higher of:

  • an amount equal to 3 months’ interest on what you still owe
  • the interest rate differential (IRD)

The lender will usually use the IRD calculation if:

  • the interest rate on your mortgage is higher than the current interest rate and
  • you signed your current mortgage contract less than 5 years ago

The calculation of the IRD may depend on the interest rate in your mortgage contract. Lenders advertise interest rates for the mortgage terms they have available. These are called posted interest rates. When you sign your mortgage contract, your interest rate may be higher, or lower than the posted rate. If your interest rate is lower, it’s called a discounted rate.

Calculation of the IRD

To calculate the IRD, your lender typically uses 2 interest rates. They calculate the entire interest fees left to pay on your current term for both rates. The difference between these amounts is the IRD.

To do so, they can first use one of the following interest rates:

  • the posted rate at the time you signed your mortgage contract
  • your current rate or discounted rate as described in your contract

Your lender can calculate a second interest rate based on the following:

  • the current posted rate for a term with a similar length
  • the current posted rate for a term with a similar length minus the discount you were originally offered

Example of a prepayment penalty calculation

Suppose you want to break your mortgage contract to get a new contract with a lower interest rate. You want to estimate how much the prepayment penalty will be.

Assume the following:

  • outstanding mortgage balance: $200,000
  • current interest rate: 6%
  • number of months left in term: 36 months left in a 5-year term
  • current posted interest rate for a mortgage with a 36-month term offered by your lender: 4%

The approximate fees are:

  • amount equal to 3 months’ interest on what you still owe: $3,000
  • IRD: $12,000

You have to pay a prepayment penalty of $12,000, which is the higher of the 2 amounts. You may also have to pay an administration fee.

Review your mortgage contract to find out exactly how your lender will calculate your prepayment penalty. Check with your lender for the actual amount. Ask your lender to explain anything you don’t understand.

Learn more about your rights and responsibilities with mortgage prepayment.

Tips to reduce or avoid prepayment penalties

Consider the following options to reduce the amount of money you pay in penalties.

Make full use of your prepayment privileges

Make full use of your prepayment privileges every year. Any future prepayment penalties will be based on a lower mortgage balance.

Make a lump-sum prepayment before you break your mortgage. Some lenders restrict your ability to prepay if you’re close to the date you break your contract.

Wait until the end of your term to prepay

Consider waiting until the end of your term to prepay if your prepayment penalty will be a large amount. You can then make a lump-sum prepayment without penalty.

Port your mortgage

If you’re buying a new home, ask your lender if you can port your mortgage. This means taking your existing interest rate, terms and conditions with you to your new home. It saves you from breaking your mortgage contract and getting a new one.

Learn about portable mortgages and how to choose the mortgage that is right for you.

Shop around

Shop around when you renew your mortgage. Contact various lenders and mortgage brokers to check if there are better options that will offer you more flexibility.

What your lender needs to tell you

If your lender is a federally regulated financial institution, such as a bank, they have to provide certain information.

The following details must appear in an information box at the beginning of your mortgage agreement:

  • prepayment privileges
  • prepayment penalties
  • other key details

Your lender must tell you how they calculate your prepayment penalty. Your lender must also tell you what factors they use to determine the penalty. These details must be clear, simple and not misleading.

Read your mortgage contract carefully. Make sure you understand the details about penalties before you sign your contract. Ask questions about anything you don’t understand.

Learn more about your rights and responsibilities when you apply for a mortgage.

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