One of the most important and least understood topics in the mortgage world is how penalties work. The reason penalties are typically not well understood is because of their complexity, so in this guide I am going to try and break down the basics of how they work, the different types and when they apply.

What are mortgage penalties?

A mortgage penalty is typically called a “prepayment penalty” and you can think of it like the return policy for your mortgage. If for some reason you need to pay back your mortgage before the end of your agreed upon closed term, the lender will charge you a penalty to make up for the interest they were expecting to earn.

Why would I pay a penalty?

I know what you are thinking, “Tim, the reason I need a mortgage is because I don’t have the money, how or why would I ever pay it back early?” 

It is a good question and one key detail to understand is that even if you don’t actually have the money yourself to pay it all back, there may be a scenario where you want to pay it back from the proceeds of a sale or from switching to another mortgage. In both cases since you would be paying back the mortgage early you would still be subject to a prepayment penalty.

Let's look at some other reasons people end up needing to break their mortgage:

Opportunities to save money

• If you are on a fixed rate mortgage and mortgage rates drop significantly before the end of your term you may want to try and trade in your current mortgage for a new one with a lower rate. Since you would be paying it back early, there is going to be a penalty.

Life Changes

• Needing to access equity in your home to support family
• A job promotion that requires a move
•  Growing your family and needing to sell and move into something bigger (you may be able to port your mortgage but not always)
• A divorce or separation
• Needing access to equity in your home for other investments or even home renovations
• Needing to pay off debts

Receiving a large sum of money and wanting to pay off the mortgage

• Inheritance
• Bonus from work
• Winning the lottery

The above are just some of the reasons you might end up needing to pay off your mortgage early. A poll of lenders conducted by my brokerage in 2021 showed that 38% of borrowers with a five year fixed rate ended up breaking their mortgage early and paying a prepayment penalty.

What are the different types of penalties?

Now that we understand how paying back your mortgage early might happen, we need to discuss the two types of prepayment penalties that exist and when they come into play. (Note: specialty products may have different penalty structures than the basics presented below, if you are considering a specialty product make sure you ask about the penalty structure.)

For variable rate mortgages the penalty is 3 months interest. 

For fixed rate mortgages the penalty is the larger of 3 months interest or an interest rate differential penalty.

How do the penalties work? 

3 months interest penalty

Your monthly interest rate is calculated from your annual interest rate and from there 3 months interest is calculated on however much principal is remaining. For example on a mortgage with $500,000 remaining in principle and a 5.25% annual rate, the 3 months interest penalty would be:

Monthly interest rate= 5.25%12=0.4375%

3 Months Interest Penalty=$500,000*0.4375%*3=$6,562.50

Interest rate differential penalty (IRD Penalty)

An interest rate differential penalty will come into play for a fixed rate mortgage if the current rate is lower than the rate on your mortgage. This is because if you agreed to a rate of say 5.25% for five years and interest rates drop to 4% and you want to pay back your mortgage, the bank will be losing 1.25% per year when they lend the money out again.

This penalty accounts for that difference, because the number one rule with mortgages is: the bank never loses money. Unfortunately calculating this penalty is not always as straightforward as it should be because some of the banks play games and use unfair penalty structures and there are essentially two methods they can use to calculate this penalty.

Method 1: Standard IRD (the fair one)

The standard interest rate differential penalty calculation is used by most monolines and credit unions. If you need to break your mortgage, the lender will look at how long is left on your existing term and what the current interest rate is for the closest comparable term. They calculate the difference between that rate and the rate that you agreed to pay them. This interest rate difference is multiplied by your balance and the length of time you have remaining to arrive at the penalty. 

For example, let's take the same mortgage as above and assume there are 3 years left on the term when we need to break it and the rate a lender could get for a 3 year mortgage is 4.5%.

Number of months remaining=36

Current interest rate for a 3 year morgtage=4.5%

Interest rate difference=5.25%-4.5%=0.75%

Monthly interest rate difference=0.75%12=0.0625%

IRD Penalty=Interest rate difference*balance*months remaining=0.0625%*$500,000*36=$11,250

Method 1: Discounted IRD (the less fair one)

The big banks (RBC, CIBC etc.) use a different method that can make the penalty even bigger. They do this by using posted rates on their websites, which they can manipulate and are higher than rates they actually give on their mortgages. When you get a mortgage, they compare the rate they gave you with the posted rate to say they are giving you a “discount”. If you ever need to break your mortgage they apply your initial "discount" to their current posted rate for the remaining term and use that to calculate the interest rate difference. 

Let's look at the same example except this time we will assume the banks original posted rate was 6.79% and their current 3 year posted rate is 5.89%.

Number of months remaining=36

Initial Posted Rate=6.79%

'Discount'received=6.79%-5.25%=1.54%

Posted rate for remaining term 3 years=5.89%

'Discounted' Interest rate for remaining term=5.89%-1.54%=4.35%

Interest rate difference=5.25%-4.35%=0.90%

Monthly interest rate difference=0.90%12=0.075%

IRD Penalty=Interest rate difference*balance*months remaining=0.075%*$500,000*36=$13,500

What this allows banks to do is increase penalties by artificially lowering the posted rates. So when rates drop and they have too many people breaking their mortgages they can drop their posted rates and crank up the penalties. It does not mean you should ever use these lenders, it just means you need to be aware of how they calculate their penalties and make your decisions accordingly.

Key Takeaways

Understanding mortgage penalties isn't just about knowing they exist - it's about making informed decisions for your financial future. While nobody takes out a mortgage planning to break it early, life has a way of throwing curveballs, and as we saw, nearly 40% of five-year fixed mortgages get broken before their term is up.

When shopping for a mortgage, make sure to ask your broker or lender these key questions:

• How do you calculate your prepayment penalties?
• Do you use posted rates or actual rates for IRD calculations?
• What are my prepayment privileges that won't trigger penalties?

Remember, the lowest rate isn't always the best deal if it comes with unfair penalty calculations. Sometimes paying a slightly higher rate with a lender who uses fair penalty calculations can save you thousands if you need to break your mortgage early.

Want to know exactly what your penalty would be? Give your lender a call - they can give you the exact amount for your specific situation.