Understanding Mortgage Penalties: What Homeowners Need to Know

When you break a mortgage before the end of its term, lenders often charge a penalty. This is a common situation for homeowners in Ontario who need to refinance, sell their home, or switch lenders. The goal of this article is to help you understand those penalties. Let’s break down the penalties associated with fixed-rate and variable-rate mortgages and explore the pre-payment privileges that can help you save money.

Fixed-Rate Mortgage Penalties

Fixed-rate mortgages have a set interest rate for the entire term, offering stability and predictability. However, breaking a fixed-rate mortgage comes with penalties. The most common penalties are calculated using the greater of:

Interest Rate Differential (IRD): This is the difference between your original interest rate and the lender's current rate for a term similar to the remaining term of your mortgage. The penalty is usually the difference in rates multiplied by the remaining balance and the number of months left on the term.

Example: If you have a 5-year fixed mortgage at 5.5% with 2 years remaining, and the current rate for a 2-year fixed term is 4%, with a remaining balance of $300,000 the IRD calculation would be:

-            Original Interest rate = 5.5%

-            Current rate for 2-year fixed term = 4%

-            Remaining balance = $300,000

-            Time remaining = 2 years (24 months)

IRD = (original interest rate – current rate) * mortgage balance * months remaining/12.

IRD = (0.055-0.04) x 300,000 x 2

IRD = 0.015 x 300,000 x 2

IRD = 0.015 x 600,000

IRD = 9,000

Therefore, IRD penalty is $9,000.

Three Months’ Interest: Lenders also use a simpler calculation where they charge you three months’ worth of interest on your remaining balance.

Example: If your remaining balance is $300,000 with an interest rate of 5.5%, the calculation would be:

-            Remaining balance = $300,000

-            Interest rate = 5.5%

Three months’ interest = remaining balance x interest rate x 3/12

Three months' interest = 300,000 x 0.055 x 0.25

Three months' interest = 300,000 x 0.01375

Three months' interest = 4,125

Therefore, the three months’ interest penalty would be $4,125

Variable-Rate Mortgage Penalties

Variable-rate mortgages have interest rates that fluctuate with the prime rate, making them more unpredictable. The penalty for breaking a variable-rate mortgage is typically less complicated. It is most common that lenders will charge a penalty of three months’ interest on the remaining balance of the mortgage.

Example: With a $400,000 remaining balance at a current rate of 4.5%, the penalty would be $400,000 * 4.5% * 3/12. Therefore, the penalty would be $4,500.

Pre-Payment Privileges

To avoid or reduce penalties, it’s important to understand and utilize pre-payment privileges. These are terms in your mortgage contract that allow you to pay extra amounts toward your principal without incurring penalties. Pre-payment privileges will vary depending on your lender, and the terms of your mortgage. Common pre-payment options include:

Lump-Sum Payments: Many Ontario lenders allow you to make a lump-sum payment of a certain percentage of the original principal amount each year. This typically ranges from 10% to 20%.

Increased Monthly Payments: You can often increase your regular mortgage payments by a certain percentage, typically up to 100%.

Double-Up Payments: Some lenders allow you to make additional payments equal to your regular payment at any time.

If you are looking to pay off your mortgage faster, applying your pre-payment privileges are an excellent way to do so. If you are unaware of what your current privileges are, or what the options are for your upcoming mortgage, I am here to help you. Book a meeting with me!

Conclusion

Understanding mortgage penalties and pre-payment privileges can save you a significant amount of money and stress. Whether you have a fixed-rate or variable-rate mortgage, knowing how penalties are calculated and how you can utilize pre-payment options will empower you to make informed decisions. Always consult with your lender or mortgage professional to get the specific details applicable to your mortgage.

By keeping these points in mind, you can navigate the complexities of mortgage penalties and pre-payment privileges with confidence.