Mortgage Prepayment Penalties

When a borrower takes out a mortgage, they are agreeing to a contract for a set period. If they choose to break this agreement by paying off the mortgage early, the lender will impose a mortgage prepayment penalties. The details of this penalty are outlined in the lender’s standard charge terms. However, many borrowers are unclear about how these penalties are calculated and when they apply. Below, we will explain how to estimate these penalties.

Example- Fixed Interest Rate

John has a 5-year fixed-rate mortgage with East York Mortgage Bank. When Unrate helped him secure his mortgage, they locked in a rate of 3.55%. Now, John is nearing the end of his third year, with two years left on the term, and he wants to pay off the remaining balance of $270,000 in full. East York Mortgage Bank applies the greater of two penalties: a three-month interest penalty or the interest rate differential penalty. To figure out which penalty applies, both need to be calculated to identify the higher amount.

Three Months Interest Penalty

This option requires the borrower to pay three months’ worth of interest as a penalty. This is usually calculated by taking the outstanding balance, multiplying it by the interest rate, and then dividing the result by four (since there are four quarters in a year).

penalty = outstanding balance x current rate / 4

penalty = $270,000 x 3.55% / 4

penalty = $270,000 x 0.0355 / 4

penalty = $9,585 / 4

penalty = $2,396.25

Interest Rate Differential Penalty

The interest rate differential (IRD) is calculated as the difference between the borrower’s current mortgage rate and the lender’s current available rate for a similar-term mortgage. This difference is then multiplied by the outstanding balance and the remaining time on the mortgage term to determine the exact penalty amount. This type of penalty usually applies when the borrower’s current mortgage rate is higher than the lender’s current rate for new mortgages. When the borrower prepays the mortgage, the lender is forced to lend that money at the current lower rate. The penalty compensates the lender for the loss, which is the difference between the income it would have earned from the higher-rate mortgage and what it will now earn from lending at the new, lower rate.

Fixed Interest Rate Differential Calculation Example

It’s essential to find out East York Mortgage Bank’s current rate for a new two-year mortgage term. This is important because John has two years left on his mortgage, and the lender will compare his existing rate to their current rate for a two-year term. In this case, the bank’s rate for a new two-year term is 2.50%. With this information, we can now calculate the penalty.

penalty = (outstanding balance x (John’s current rate – East York Mortgage Bank’s rate)) x number of years

penalty = $270,000 x (3.55% – 2.50%) x 2

penalty = $270,000 x 1.05% x 2

penalty = $270,000 x 0.0105 x 2

penalty = $2,835 x 2

penalty = $5,670

From these calculations, it’s clear that East York Mortgage Bank will apply the higher penalty, which is the interest rate differential.

Variable Interest Rate Differential Calculation Example

Variable rate mortgages are different than fixed rate. The interest rate you pay is generally aligned with the rate offered by your lender to new customers. For instance, if John’s variable rate is 3%, that would match the rate North York Bank is offering to new clients. In this case, there wouldn’t be an interest rate differential. However, for a partially open mortgage, there would still be a penalty equal to three months’ interest.

That said, this isn’t always how it works. If North York Bank provided John with a variable rate that included a discount, this discount would need to be factored in when calculating any potential penalty. For example, if John’s variable rate was set at the bank’s prime rate minus 1%, and his current rate of 3% is 1% below the bank’s current prime rate, the bank would calculate both an interest rate differential and a three-month interest penalty, then charge John whichever amount is higher.

Are there any mortgage prepayment penalties if if pay off my mortgage at renewal?

mortgage prepayment penalties do not apply when you pay off your mortgage or make additional payments at your mortgage renewal – at the end of its term. Here’s why:

1. End of Term: At the end of your mortgage term, your contract with the lender expires. This means you’re free to pay off the balance, renew with the same lender, or move your mortgage to another lender without penalties.
2. Prepayment Clauses: Prepayment penalties typically apply only if you pay off your mortgage in full or make extra payments beyond the allowable amount before the end of the term.
3. Check Your Contract: Some lenders may include specific clauses regarding renewals or transfers, but penalties for paying off at renewal are rare.