Understanding Mortgage Penalties

When it comes to mortgages, it’s easy to focus on the rate and term. However, the reality is that life happens, and when it does, your rate and term won’t be the only things that matter.

First and foremost, it’s important to remember that a mortgage is a contract. This means there can be penalties if the contract is broken. Although this is something you agree to as a homeowner when you sign a mortgage commitment, it’s often easy to overlook—until you’re faced with the cost.

Why Break Your Mortgage?

You might wonder why you would ever break your mortgage contract. Surprisingly, 6 out of 10 mortgages in Canada are broken within three years, and there are typically nine common reasons for this:

• Sale and purchase of a new home
• Utilizing equity
• Paying off debt
• Cohabitation, marriage, and/or children
• Divorce or separation
• Major life events (illness, unemployment, death of a partner)
• Removing someone from title
• Getting a lower interest rate
• Paying off the mortgage

It’s always important to think ahead when signing a mortgage agreement, but not everything can be planned for. In the event of an unexpected situation, it’s crucial to understand the next steps if you need to break your mortgage.

Calculating Penalties

When breaking a mortgage, the penalty is typically calculated in one of two ways. Lenders generally use either an Interest Rate Differential (IRD) calculation or a three-month simple interest calculation. For fixed-rate mortgages, the penalty will be the greater of these two amounts. For variable-rate mortgages, you typically pay only three months of interest.

Interest Rate Differential (IRD)
The Interest Rate Differential (IRD) penalty is one of the prepayment penalties that may apply when you pay off your mortgage early.

Here's a simple explanation:

The IRD penalty is based on the difference between your current mortgage interest rate and the interest rate the lender could now charge for the remaining term of your mortgage.

To calculate it, the lender compares:

1. Your current mortgage rate - The interest rate you're paying on your existing mortgage.
2. Current market rate - The interest rate the lender would offer for a new mortgage with a term that matches the remaining time on your existing mortgage.

The IRD penalty is typically the difference between these two rates, multiplied by your outstanding mortgage balance and the number of months left in your term. In simple terms, the IRD penalty compensates the lender for the loss they incur by not being able to lend out the remaining mortgage amount at the higher rate you were paying.

Three Months’ Interest
In some cases, the penalty for breaking your mortgage is simply equivalent to three months of interest. A variable- or adjustable-rate mortgage is usually accompanied by only the three-month interest penalty.

Paying the Penalty

When it comes to paying the penalty, some lenders may allow you to add this amount to your new mortgage balance (meaning you would pay interest on it). You can also choose to pay the penalty upfront.

Whenever possible, if you can wait out your current term before making changes to your mortgage, it may be the best way to avoid penalties. If you cannot avoid a penalty, keep in mind that while online calculators can be useful for estimates, it’s best to contact your lender directly for an accurate penalty amount—or feel free to reach out to me.