This article has been updated from a previous version.
If you decide to break your mortgage, whether it’s a variable or a fixed one, you will have to pay a prepayment penalty.
When you break a mortgage, your lending institution loses out on the interest payments expected over the length of your mortgage. The penalty is the price you pay for breaking the contract. The penalty amount depends on the type of mortgage you have: variable or fixed.
Breaking a mortgage early can be tempting, especially if you’re in a position to get a lower interest rate and potentially save thousands of dollars over several years or decades. That might be worth the upfront penalty costs. But before you call up your mortgage broker or your bank, let’s look at how these break-early mortgage penalties work and when it actually makes sense for you to break your mortgage.
When should you consider breaking your mortgage?
This is where you need to do the math. When you run the numbers, you want the penalty you’ll be paying to be less than the benefits you’ll gain — i.e., the amount of money you’ll save over the length of your mortgage. If the penalty you’re paying is more than what you’ll save during your mortgage term, then it’s not worth breaking it for a lower rate.
Your lender may calculate your prepayment penalty based on:
- The number of months left in your mortgage term
- The remaining balance on your mortgage
- The interest rate you’re currently paying on the mortgage
- The interest rate offered for a mortgage with the same term as what’s left on your mortgage
Now let’s look at the amount you’ll pay in penalties.
Prepayment penalties: Variable versus fixed
When it comes to breaking a mortgage, variable-rate mortgages tend to be the more attractive option. When you break a variable-rate mortgage, you will usually have to pay a penalty of three months’ worth of interest on what you still owe on the loan.
With fixed-rate mortgages, however, your lender will calculate two things: three months’ interest and what’s called the interest rate differential (IRD).
The IRD is typically calculated using two interest rates — your current interest rate, and the rate your lender could charge today on a mortgage with a similar term as what’s remaining in your mortgage. The difference between the two is the IRD.
With most fixed-rate mortgages, you’ll have to pay the greater of the two options if you decide to break your mortgage. So, if the three months of interest is more than the IRD, you’ll pay that amount as your penalty. And vice versa.
How to minimize prepayment penalties
There are ways to reduce — and in some cases, maybe even avoid altogether — these penalty fees when you’re breaking a mortgage:
- Do the math yourself. Big banks have been subjected to class action lawsuits for how they calculated mortgage prepayment penalties that led to massive fees for mortgage holders. Your lender will do its own calculations but don’t rely solely on their numbers.
- Port your mortgage. If you’re breaking your mortgage so you can buy a new home, porting your current mortgage to the new home can save you from paying penalty fees, as you’re not breaking the mortgage. Ask your lender if your mortgage is portable. (This is one reason why you should consider getting a mortgage with this flexibility.)
- Wait until the end of your term to walk away. If you can wait, break your mortgage when you’re near the end of your term. It’s not wise to break it in the first year, but you can consider breaking it if you’re in, say, the fourth year of a five-year mortgage term when the interest penalties will be lower.
- Max out prepayments. If you think you might break your mortgage at some point in the future, take advantage of prepayments now. You’ll pay down your mortgage faster so when you do break it, you’ll have a smaller balance, which means less money lost to penalties.
- Compare the market. When it is time to renew your mortgage, it’s in your best interest to see what else is out there. Use online comparison tools to compare mortgage rates from a number of providers to find the best rate for your needs.
Whatever you decide to do, run the numbers yourself and compare them to those provided by your lender. You want to make sure that you’re going to benefit from breaking a mortgage, and not just paying a lot of money in fees.
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