If you end your mortgage before maturity (i.e., break your mortgage), you normally have to pay a penalty. The one exception is with an open mortgage, which you can repay in full whenever you want without having to pay a penalty. However, this flexibility comes at a cost: An open mortgage has a higher interest rate than a closed mortgage.
The financial institution determines the penalty you will have to pay to break your mortgage. The way the penalty is calculated, including the interest rate that is used, varies slightly from one financial institution to the next.
If you have a closed mortgage with a variable interest rate, the applicable penalty usually amounts to three months’ interest.
How penalties are calculated if you break your fixed rate mortgage
Financial institutions usually charge the higher of:
- an amount equal to three months’ interest on your current mortgage, or
- an amount determined based on the interest rate differential
Simply put, the financial institution calculates the shortfall resulting from a drop in interest rates. Therefore, it can be a challenge to try to save money by breaking your fixed rate closed mortgage in order to benefit from a lower rate. The calculation looks like this:
| Mortgage balance | × | (Posted annual interest rate at signing1 – Current posted annual interest rate2) | × | Years remaining on your mortgage | = | Penalty payable |
1. The posted annual interest rate at signing is the rate you are currently paying, plus the rate discount you received.
2. By using posted rates, the financial institution can refer to two comparable rates.
Example
John is taking steps to find out the penalty he would have to pay to break his mortgage. He has a $200,000 balance on his closed mortgage, and there are 4 years remaining on his contract. The annual interest rate is fixed at 3%. When he signed his loan application, the rate posted by his financial institution was 4.5%. The current posted interest rate for a 4-year mortgage is 4.09%.
His financial institution informs him that he will have to pay the higher of the two penalties determined using the above methods, i.e., the 3 months’ interest method or the interest rate differential method.
Three months’ interest penalty
Calculate three months’ interest:
12 months’ interest = $6,000 ($200,000 X 3% = $6,000)
3 months’ interest = (3 X $6,000 / 12) = $1,500 (approximate amount*)
*A more precise calculation would result in a slightly lower penalty of $1,490.
Check what rate is used: Is it the rate you are paying or the posted rate?
Interest rate differential penalty
Mortgage balance1 | X | (Posted annual interest rate at signing2 - Current posted annual interest rate 3) | X | Years remaining on your mortgage | = | Penalty payable |
| $200,000 | X | 4,5% - 4,09% | X | 4 years | = | $3,280 |
1. Mortgage balance
Here’s a tip to limit the penalty for breaking your closed mortgage. Financial institutions generally let you repay a portion of the borrowed amount without penalty. This is called a prepayment privilege. Before taking steps to break your mortgage and paying the applicable penalty, first check whether you can repay the amount you’re allowed to put toward your mortgage without penalty. Doing this could bring down the mortgage balance used for the calculation, resulting in a smaller penalty.
2. Posted annual interest rate at signing
Check the interest rate used to calculate the penalty. Financial institutions do not necessarily use the interest rate that you’re paying when they determine the penalty. Check the rates used in the calculation, as they have a significant effect on the penalty payable.
3. Current posted annual interest rate
This is the interest rate you could receive for the years remaining on your mortgage. For example, if you have 4 years left on your 5-year mortgage, the rate used is generally the one in effect for a 4-year mortgage. Some lenders use the posted rate less the rate discount you received.
Be careful: In addition to the above penalty, financial institutions may charge you an administration fee. If you break the contract during the first term, they may also charge a reinvestment fee. So before signing your loan contract, read it carefully. Pay particular attention to the conditions for breaking the contract during the first term. These vary from one financial institution to another.
Fee reimbursem*nts or cashbacks upon signing the agreement
If you were reimbursed for fees or got a cashback upon signing the agreement (e.g., payment of notary fees), these amounts may be considered in calculating the penalty. The penalty would therefore increase.
Suppose you received a $2,000 cashback upon signing a 5-year mortgage agreement. To break the mortgage after one year, in addition to the penalty calculated above, the institution could add a $1,600 penalty, i.e., 4/5 of $2,000 for the 4 years remaining on the initial 5-year contract.
Tip to limit the risk of paying a large penalty
Although many people choose 5-year closed mortgages, a 5-year term might not be right for you. The longer the term, the greater the chance that you will pay a large penalty for breaking your mortgage. Ask yourself whether you might want to break your mortgage if:
- You separate from your spouse;
- You have a child;
- You lose your job;
- There’s a drop in interest rates and you want to benefit from it.
If so, check whether a shorter-term mortgage might make sense for you.
Insight
Before choosing your mortgage lender
Find out about what the penalties would be for breaking your mortgage. They can run in the thousands of dollars.
Ask your financial institution to calculate the penalty it would charge you if you were to break your mortgage after two years, assuming a 1% decrease in the interest rates available on the market.
End of the insight
References
Mortgages: It pays to do your homework!
Types of mortgages
Mortgage features
8 tips for saving money on your mortgage
Residential mortgage brokers
Checklist for choosing your mortgage
