Prepayment penalties can cost you thousands of dollars. It’s important to know when they apply and how your lender calculates them. Prepayment penalties are often overlooked, but should be included in your main criteria when choosing a mortgage, as they may significantly impact your mortgage payment options and costs. Here is why and how.
A prepayment penalty (also called prepayment charge or breakage cost) is a fee that your mortgage lender may charge if you:
- pay back your entire mortgage before the end of your term, including when you sell your home
- transfer your mortgage to another lender before the end of your term
- pay more than the allowed prepayment or lumpsum amount toward your mortgage
- break your mortgage contract
If you have an open mortgage, you can make a prepayment or lump-sum payment without paying a penalty. 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.
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 or make lump-sum payments up to a certain amount or percentage of the original mortgage amount. Your lender may not offer prepayment privileges or may place limits and other conditions (e.g. timing of payments, minimum/maximum amounts, fees, penalties, etc.)
How to reduce / avoid prepayment penalties
Consider the following options to reduce the amount of money you pay in penalties:
Shop around when you get or renew your mortgage. Contact various lenders and mortgage brokers to check if there are better prepayment and penalty options that will offer you more flexibility.
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, although some lenders may 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 if your prepayment penalty will be a large amount. You can then make a lump-sum prepayment without penalty.
Ask your lender if you can port your mortgage buying a new home. 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.
How much prepayment penalties cost
The way your prepayment penalty is calculated varies from lender to lender and depends on factors such as the amount you want to prepay, the number of months left until the end of your term, interest rates, and 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.
How is Interest Rate Differential (IRD) Calculated?
To calculate the IRD, your lender typically uses two 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 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: $500,000
- current interest rate: 4%
- 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: 3%
The approximate fees are:
- amount equal to 3 months’ interest on what you still owe: $5,000 (= $500,000 x (4% year / 12 months) x 3 months)
- IRD: $15,000 (= $500,000 x (4% – 3%) / 12 months) x 36 months)
You have to pay a prepayment penalty of $15,000, 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.
As always, contact me with your questions or to help you find a mortgage broker/lender to suit your specific needs. I am waiting for your call.