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Paying Your Mortgage Early? Watch Out for the Mortgage Prepayment Penalty

Paying Your Mortgage Early? Watch Out for the Mortgage Prepayment Penalty

Prepayment penalties apply when the borrower makes a mortgage payment that exceeds the prepayment privileges laid out in the mortgage contract. A prepayment can occur when the borrower does any of the following:

  • Applies a lump sum payment to the mortgage over the allowable amount
  • Pays off the mortgage in full before the end of the mortgage term
  • Transfers the mortgage to a different financial institution before the end of the mortgage term

What Is a Prepayment Privilege?

Even if your mortgage is closed, most lenders will allow for prepayment privileges. In other words, they give you the ability to pay the mortgage off ahead of schedule without incurring a penalty. Prepayment privileges vary by lender, but they usually include the following:

Applying Lump Sum Payment

Your mortgage lender should allow you to make lump-sum payments up to a certain percentage of the original principal amount each calendar year. The maximum annual percentage rate can range between 10% and 20%.

For example, let’s say that your original mortgage was $200,000. Your lender allows you to make annual lump sum payments of 15% of the original principal ($200,000). Regardless of the mortgage amount owing, you can make a lump-sum payment, or payments, totalling $30,000 each year.

Increasing your Regular Payment

In addition to the lump-sum payment, most lenders will allow you to increase your regular monthly or biweekly price. Some lenders will let you increase it by 100%; others will limit the increase to 15% or 20%.

Using 100% as an example, if your bi-weekly principal and interest payments are $750, you would be able to increase to as much as $1500 biweekly. Just imagine how much more quickly you could pay your mortgage off by taking advantage of these prepayment privileges.

Choosing a Rapid Weekly/Bi-Weekly Payment

As you may be aware, if you apply a rapid payment option to any loan or mortgage, you will pay it off early. A rapid biweekly payment is 50% of the monthly payment, slightly higher than a regular biweekly payment, which equates to 12 monthly payments spread over 26 bi-weekly periods.

On a regular bi-weekly repayment, each installment is less than 50% of the monthly payment. Choosing a rapid payment option requires a minor adjustment to your monthly budget, but the long-term impact is significant. If you were to select rapid payments on a brand new mortgage with a 25-year amortization, you would pay the mortgage off almost four years ahead of schedule.

Types of Prepayment Penalties

There are two types of prepayment penalties: Interest Rate Differential (IRD) and a 3-month interest charge. With most closed, fixed-rate mortgages, the penalty will be the greater of the two. With most variable-rate mortgages, there is no IRD, and the penalty defaults to the 3-month interest charge.

How to Calculate the Interest Rate Differential (IRD)

The Interest Rate Differential compensates the lenders for lost interest when the borrower decides to break the mortgage contract before the end of the term. Because lenders borrow the money they use to fund mortgages, they rely on revenue from mortgage interest to meet their borrowing obligations (interest on deposit balances). Also, mortgage lenders profit from the spread between the two rates.

Example of an IRD Calculation

Let’s say you have a $200,000 mortgage balance with a 5-year term and a posted interest rate of 4.5%. If, after two years, you decide to transfer the mortgage to another institution, your lender has suddenly lost the interest they were counting on over the next three years to cover their expenses and make a profit.

They can turn around and re-lend the money to someone else, and they will, but what happens if the interest rate has dropped, and they can only lend at a rate of 3.0%. The bank needs to recoup the difference. To illustrate here’s a straightforward IRD calculation:

  1. 4.5% (your current rate) – 3.0% (current posted rate for a 36-month term) = 1.5%
  2. 1.5% X $200,000/12 months = $250
  3. $250/month X 36 months remaining = $9,000 IRD

In this case, a 3-month interest charge would only be $2,250, so the IRD of $9,000 would apply because it’s the higher of the two.

  • 3-month Interest Charge: $200,000 X 4.5%/12 = $750 X 3 months = $2,250

Additional Thoughts on IRD

To determine the difference between your current rate and what the bank can offer today, lenders can go one of two ways.

They can use posted rates, not including rate discounts, or they may use your current discounted rate, and apply a similar discount to the current market rate.

Generally speaking, the earlier you are in your mortgage term, the better the chance you will be charged an IRD rather than a 3-month interest charge. Another major factor is the current rate environment.

If current mortgage rates are much lower than the rate you’re paying, the IRD will be higher. Conversely, if current rates are higher than your rate, the IRD may be negligible.

Mortgage Prepayment Glossary

Unless you deal with mortgages regularly, you may not be familiar with the related terminology. To help you better understand what it all means, I’ve compiled the following list of mortgage prepayment terms:

Closed Mortgage – A closed mortgage cannot be repaid in full during the mortgage term without applying a prepayment penalty. Even partial prepayments may incur a penalty if they extend beyond the allowable amount.

Fixed-Rate Mortgage – A fixed mortgage rate does not change during the entire length of the mortgage term, usually between 1 and 5 years. With most mortgage lenders, the prepayment penalty charged on a fixed-rate mortgage is the IRD or the 3-month interest charge, whichever is higher when the prepayment is applied.

Interest Rate Differential (IRD) – The interest rate differential is a type of prepayment penalty. The methodology used in calculating the IRD can differ slightly between lenders, but in general terms, it’s the difference between your current mortgage interest rate and current interest rates. The methodology can vary somewhat between lenders,

3-Month Interest Charge – The 3-month interest charge is a type of prepayment penalty that works much as it sounds. The lender calculates 90 days of interest, based on the current mortgage rate, and the resulting amount is charged as a penalty on the amount of the prepayment.

Mortgage Discharge Fee – When you pay off your mortgage in full, the lender will apply a discharge fee regardless of the reason. This fee covers the administration costs the lender incurs to discharge their security from the property title. Discharge fees can vary but are usually $100 – $200. The discharge fee is disclosed in the mortgage lending agreement when the mortgage is activated.

Mortgage Prepayment Privilege – Allows the borrower to make additional payments without incurring a penalty. Almost every closed mortgage includes a set of prepayment privileges, but they do vary between lenders.

Mortgage Refinance – When a borrower takes out a new mortgage loan, replacing the previous mortgage. In most cases, a refinance involves an increase in the mortgage lending amount.

Mortgage Transfer – When a borrower moves their mortgage to a different lender, the process is known as a mortgage transfer.

Open Mortgage – An open mortgage can be paid in part or in full at any time, without a penalty. Most lenders offer a 1-year open term, as well as a 5-year open variable mortgage. Open mortgages do not incur prepayment penalties; however, they may include an administration fee.

Prepayment Penalty – Charged on a mortgage when a prepayment is applied that is beyond the prepayment privileges. A prepayment penalty can be either the IRD or a 3-month interest penalty.

Variable Rate Mortgage – With a variable interest rate mortgage, also known as a floating rate, the interest rate moves up and down along with the Bank of Canada Prime Rate. Most variable-rate mortgages are Prime plus or minus. For example, a variable rate of Prime -.50% would be 1.95% if the Bank of Canada’s Prime Rate is 2.45%.

Final Thoughts on Mortgage Prepayment Charge

When it comes to mortgage penalties, your best bet is always to plan ahead. Before you sign a mortgage contract, understand your prepayment privileges and how the prepayment charges, if any, will be calculated. Also, keep mortgage portability in mind. If you decide to buy a new home before your term expires, your lender may allow you to transfer your mortgage to the new property without incurring penalties. Lenders refer to this as porting a mortgage. Either way, educate yourself, so you don’t end up shocked by unexpected interest fees.

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