Mortgage Prepayment Penalties
Some mortgages penalize you if you make extra payments against the principal or pay the loan off before the maturity date for your mortgage term. This penalty is called a prepayment penalty.
Here are the situations where you should avoid a mortgage with a prepayment penalty:
- You move frequently, and may need to sell your home before your term comes up for renewal.
- You want to accelerate the payoff of your mortgage to get out of debt sooner on a loan with a longer term.
- You are concerned that interest rates will drop, and you will find yourself stuck in a higher interest loan.
How Prepayment Penalties Are Calculated
Lenders use a formula known as the Interest Rate Differential (IRD) to calculate how much interest the lender would have earned if you didn’t pay the loan off. This protects the lender. It is common practice for the lender to take the interest payments received from all its mortgages and lend this money out to make even more money.
The IRD is calculated by taking the balance you owe in principle and comparing your interest rate with that the bank is currently able to earn on the money it’s lending today. Your penalty can be this figure or it can be 3-months’ interest payments, whichever is greater.
For example, if you have two years left on a $100,000 loan with a current interest rate of 5% and you didn’t get any discounts on your posted rates, and the lender was using 3.75% as the comparison rate, the IRD penalty would be $2,500. If you did get a discount of say 1.5%, the lender would penalize you $5,500 using the same comparison rate.
If the lender doesn’t use the discount as part of the calculation, your penalty will be smaller.
Lenders tend to use their current rate for the length of term that is left on your mortgage. For example, if you have 35 months left on your term, the lender will probably use the rate it is using for 3 year terms. Some lenders round down to the nearest term. Others round up.
The Interest Act prohibits lenders from charging IRD penalties when a term is longer than five years and the borrower has paid more than five years into the term. In this case, the lender cannot charge more than three month’s interest charges.
Loans Most Likely to Contain Prepayment Penalties
Almost all closed mortgages fixed or variable rate have a prepayment penalty. Some even have clauses that prevent you from breaking the mortgage early unless you can demonstrate the mortgage is being paid off from the proceeds of a sale.
Generally, the minimum penalty is 3-months’ interest. The maximum is determined by the IRD formula with the exception of terms that are past five years.
Some lenders charge administrative fees between 1-3 years. Open mortgages don’t have prepayment penalty clauses.
There is a price connected with not agreeing to a prepayment penalty. Your interest rate will be higher. This makes it a good idea to compare different mortgages. Some mortgages allow some prepayments without triggering the prepayment penalty. Only by careful comparison can you determine whether an open mortgage or a closed mortgage will work for you.
Strategies for Loans with Prepayment Penalty Clauses
Look for a loan that is portable. Portability allows you to transfer the terms and conditions of your existing mortgage to a new home. This won’t trigger a prepayment penalty.
Another strategy is to get a loan that allows a new buyer to assume your mortgage. This also won’t trigger a prepayment penalty as the bank will continue to receive the anticipated interest payments.
