A mortgage is a legally binding agreement between you and your lender—ending it early or renegotiating the terms is known as breaking a mortgage and it will cost you.
But how much can you expect to pay in penalties? What factors determine the cost of breaking a mortgage in Canada? Is a penalty always imposed?
Read on for the answers.
How Much Does it Cost to Break a Mortgage Contract?
How much a mortgage break penalty will cost you depends on the type of mortgage you have.
Open mortgages, which allow you to make repayments whenever you can, do not impose any penalties for breaking the contract.
Closed mortgages, on the other hand, typically involve a prepayment penalty which can go up to thousands of dollars should you decide to end the contract early.
How much is a prepayment penalty on a mortgage?
The fee varies from one lender to the next and it also depends on other factors, such as whether you have
- A fixed or variable rate loan
- The amount and months you have left until the end of the loan term
- How your lender calculates the fee
Typically there are two methods lenders use to determine the penalty for paying your mortgage early.
If you have a variable-interest loan your loan provider will use the first one. For borrowers with fixed-rate loans, the lender will choose the higher sum of the two.
3 months of interest
As the name suggests, the mortgage break fee is equal to 3 months worth of interest on your outstanding mortgage balance. Here is an illustration.
- You have three more years on a 5-year fixed-rate mortgage
- You owe $200,000
- Your interest rate is 6%
- You would need to pay $3,000 (200,000 × 0.06 × (3/12)
Interest rate differential (IRD)
The IRD is designed to compensate the lender for the interest they will lose if a borrower ends the contract before it is up. This method is used with fixed-rate mortgages only, and unlike the previous one, it is a bit more complicated to determine.
When calculating the IRD, your lender uses two interest rates—the difference between the amount of interest left on your current mortgage for both rates is the IRD.
Lenders use either one of these interest rates
- The posted rate when you signed the original contract
- The discounted rate described in your contract
The second interest rate is based on
- The current posted rate for a mortgage term with a similar length
- The current posted rate for a mortgage term with a similar length minus the discounted price you were offered when you signed your mortgage agreement.
|The interest rates advertised by lenders for the mortgage terms they offer are called the posted interest rates. If your interest rate is lower than the posted rate, you are paying what is known as a discounted rate.|
A bit complicated, right? Here is an example of how it works.
- You have three more years on a 5-year fixed-rate mortgage.
- You owe $200,000
- Your interest rate is 6%
- The current interest rate for a 3-year mortgage offered by the same lender is 4%.
- The IRD would be $12,000
The lender calculates the difference between the two rates (0.02) and divides it by 12 to get the monthly interest rate (0.00169). Then they multiply the monthly rate by 36 months (0.06) and then by your $200,000 principal remaining.
As you can see from the example, the IRD is much higher than the 3 months of interest left on your loan (in this case $3,000), which means your prepayment penalty will be the higher of the two amounts, i.e. the IRD.
Luckily, you won’t have to do all this calculation yourself—you can use a penalty mortgage calculator to determine the final fee (both for variable and fixed-rate mortgages).
Although the prepayment penalty is the biggest cost of breaking a mortgage early in Canada, your lender might impose other fees, which may include:
- Administration charges
- Reinvestment fees
- Appraisal costs
- A mortgage discharge fee
You might also have to repay part of the principal you borrowed when you took out the mortgage.
Whether or not you need to pay these charges (and how much they will cost) depends on your lender, which is why reading the terms and conditions before signing for a mortgage (or any loan) is an absolute must.
If you decide to break your mortgage, talk to your loan provider and add the additional costs to your calculations.
|Related: How to find the best mortgage lender for your needs?|
Reasons for Breaking a Mortgage
There can be a few reasons why someone would opt for breaking their mortgage early.
Most homeowners choose to refinance to consolidate debts. Say you have accumulated credit card debt or you have other types of loans that you are paying off at a high-interest rate. The advisable course of action would be to negotiate a new mortgage and roll your debts into one loan offered at a lower interest rate.
The important thing with debt consolidation is to find a better rate than the one you are offered right now. Also, make sure that the overall cost of the new loan is not higher than the penalties you would have to pay for breaking your mortgage contract.
2. Switching lenders
Your current mortgage might not suit you anymore or you may be approached by a new lender who will offer a better rate.
Before you consider this option, make sure you determine whether the new offer is indeed cheaper than what you’re currently paying. This means including all the fees in the calculation (from prepayment penalties to administrative fees for the new mortgage). You will also need to consider the mortgage stress test, which you have to pass if you want to get approved by a new lender.
3. Lower interest rate
If interest rates are low, you could consider breaking your mortgage and switching from a variable to a fixed-rate loan, thus locking in the lower rate (which can significantly boost your monthly budget).
Similarly, if your financial situation or credit score have improved, you could be able to qualify for a better interest rate, saving thousands over the length of the loan. Even better, you could be eligible for a mortgage with a shorter amortization period so you would pay it off faster and be debt-free sooner.
4. You can no longer make monthly mortgage payments
If this is the case, then you would need to take a new mortgage with a longer amortization period. This way your monthly repayments will be lower, but you might end up paying more in interest over time, which is one of the biggest drawbacks of long-term over short-term loans.
5. Buying a new home
If you are selling your old home and porting your mortgage is not an option, breaking your mortgage early is the only available alternative. Ensure that you factor in all the penalty fees into the price of the new home to get a better idea of how much you will have to pay in total.
6. You have come into money
You might have won the lottery or come into a large inheritance that would allow you to pay off your mortgage. However, if the principal is higher than what is permitted in your contract, you would have to break your mortgage to move forward.
What to consider before breaking a mortgage?
Whatever the reason for ending your loan agreement, you want to make sure that you understand the consequences of breaking the mortgage before the term is up.
First, consider the early payment penalty and other fees. Sometimes the additional costs and penalty fee might be so high, it will offset any savings you could get from a lower interest rate. It may be better to wait till the end of your mortgage term rather than break your mortgage early.
Secondly, you need to think about the mortgage stress test and how it will affect you. Used to determine if you are able to repay the loan when (or if) interest rates rise by 2%, falling the test means you will not get approved for a new mortgage.
It’s vital to take your time and calculate all costs carefully. Read the terms and conditions of your agreement to better understand how much you will have to pay in penalties and whether or not breaking a mortgage is worth it.
Alternatives to Breaking Your Mortgage
However, you might be in a situation where you need to break your mortgage even though it is not the most cost-effective option. If so, here are a few alternatives to think about.
Port your mortgage
If you are selling your old house and buying a new one, you could port your mortgage to your new home and avoid paying the early payment penalty mortgage. You would get the same conditions (principal, term, interest rate and amortization period would be moved to the new property).
This is a great option if you want to downsize (your currency mortgage may cover the new home), but it could be less than ideal for those that want to move to a bigger, pricier house.
Have the buyer take on the mortgage
This option is only possible if you are breaking your mortgage because you are selling your home and both the buyer and the lender agree for the buyer to assume the mortgage, i.e. inherit the loan, interest rate and all. This might sound like a far-fetched scenario, but it never hurts to explore all options.
Use prepayment privileges
Prepayment privileges are additional payments you can contribute towards your mortgage every year without paying a penalty fee—either as a lump sum or as a percentage on top of your regular payments.
Before you break your mortgage, make the maximum annual prepayment possible (if you are financially able to). This way you will lower your outstanding balance and in turn your prepayment fees.
However, the FCAC notes that some mortgage providers might not allow you to make a large lump sum payment if it is deposited too close to the date when you break your mortgage.
Renew your mortgage early
Some online mortgage lenders and banks might allow you to renew your mortgage contract before it expires. This allows you to lock in a lower interest rate which might not be available when your mortgage agreement expires. Most lenders, though, will let you use this option around 4 months (120 days) before the contract is up—otherwise, you will need to pay the prepayment penalty.
Also, the renewal will have different terms, however, depending on the lender, you might continue using the old rate up to the point when your new and renewed mortgage becomes effective.
Renewal periods and conditions vary among lenders so check with yours before you decide on this option.
Blend and extend
This is similar to renewing your mortgage before the term is up, however, with this option you extend the length of the loan and get a blended rate of your current and new interest rate, so you end up somewhere between the two. There is no prepayment penalty (since you are not breaking the mortgage), but there will be administrative fees payable.
Calculating the blended interest rate is not a simple procedure, but your lender must inform you of the particulars so you will be able to decide whether this option suits you or not.
This is a simplified example of how a blended mortgage works:
- You’ve got a mortgage at a 5% interest rate and your lender is willing to offer 3%. There are 3 years left on your 5-year term.
- Instead of refinancing at 3%, you are able to get a blended rate between your old rate (5%) and the new rate (3%). The term will go back to 5 years.
Take equity out of your home
Tapping into your equity with a Home Equity Line of Credit (HELOC) might give you the money you need to break your mortgage early. You might also get a lower interest rate by refinancing your home loan.
The Takeaway: Is Breaking Your Mortgage Worth It?
It ultimately depends on your financial situation, the reason why you want to end the contract and the type of mortgage you have. For instance, if you have a variable interest rate and you want to sell your home to move to a smaller house, then breaking your mortgage can make sense. However, if you have a fixed-rate mortgage and want to consolidate debt or refinance, you could look into other options such as a second mortgage or HELOC.
Before you take this step, though, make sure that you don’t end up paying more over time—explore all alternatives open to you, whether they can lower your outstanding loan balance or reduce your prepayment penalty.
It is also helpful to talk to a mortgage professional—they will not only advise on the best way to move forward but also provide you with accurate and updated information on the mortgage market.
A prepayment penalty on a fixed mortgage is higher than the one on loans with a variable rate. It is determined using two methods and your lender will charge you the higher sum of the two. One is calculating 3 months’ worth of interest and the other is using the IRD. You can use a prepayment calculator to check both fees and decide whether or not breaking your fixed-rate mortgage early is worth it.
An open mortgage is flexible, allowing you to repay some or all of your loan at any time during the loan term without any prepayment fees. The interest is higher, but this is a good option if you know you have money coming your way allowing you to pay your loan in full without any penalties.
The cost of breaking a mortgage in Canada is typically a 3-month of interest on your mortgage’s remaining principal at the current set interest rate. If you have a fixed-rate mortgage, your lender will use the IRD to calculate how much you need to pay in penalties, which is much higher than what you’d pay to break a variable-rate mortgage.