Below is an article taken from the ‘Financial Consumer Agency of Canada’
How will my prepayment charge be calculated if I break my mortgage before the end of my current term?
ANSWER:
If you have a closed mortgage, your lender may allow you to break your contract if you pay a prepayment charge (also known as a prepayment penalty), but there are some contracts that do not provide this option. If you are allowed to do this, your mortgage contract will describe how the prepayment charge for breaking your mortgage contract will be calculated.
Depending on factors such as your outstanding balance, the number of months remaining on your mortgage term and the interest rate used in the calculation, the charge could be thousands of dollars, so before signing a mortgage contract, review the prepayment details carefully.
The prepayment charge for a closed, fixed-rate mortgage is usually the greater of:
- three months’ interest on the outstanding balance of your mortgage, or
- the interest rate differential (IRD): an amount based on the difference between two interest rates. The first is the interest rate for your existing mortgage term. The second is today’s interest rate for a term that is similar in length to the time remaining on your existing term. For example, if you have three years left on a five-year term, your lender would use the interest rate it is currently offering for a three-year term to determine the second rate for comparison in the calculation.
If you negotiated a discounted interest rate, the calculation of the interest rate differential will depend on the lender and the terms of your mortgage contract:
- Some lenders may use the posted or advertised interest rate at the time you signed your mortgage agreement and compare this to the current advertised rate for the term remaining.
- Other lenders may use your actual discounted interest rate but also apply the discount to the current rate for the comparison. In this case, the difference in rates remains the same as if advertised rates were used and the results of the calculation will be very similar.
- Some lenders may use your discounted interest rate for your existing term but willnot apply the discount to the posted interest rate used for comparison. This will usually result in a lower prepayment charge.
Below, you will find the steps to estimate your prepayment charge using each method, as well an example of a prepayment charge using each method of calculation.
Some lenders calculate the prepayment charge using a complex formula based on present value. If a present value calculation applies to your mortgage contract, you can use the steps below for the interest rate differential as a simplified way to estimate your prepayment charge. The actual prepayment charge based on a present value calculation will always be less than the amount estimated using the steps for the interest rate differential. Contact your financial institution to find out the actual amount of the charge.
Estimating the prepayment charge
a) Three months’ interest on the outstanding balance of your mortgage:
A is the outstanding balance on your mortgage
B is the annual interest rate on your mortgage
| Step 1: Identify the outstanding balance on your mortgage. | |
| Step 2: Multiply the outstanding balance by the annual interest rate on your mortgage. (Write the annual interest rate as a decimal. For example, 4% = 0.04) |
|
| Step 3: Divide the answer by 12 months in a year to get the monthly interest payable. | |
| Step 4: Multiply the answer by 3 months. | |
| Prepayment charge estimate based on three months’ interest: |
OR
b) The interest rate differential (IRD):
A is the outstanding balance on your mortgage
B is the annual interest rate on your mortgage
| Step 1: Identify the annual interest rate on your mortgage. | |
| Step 2: Identify the current interest rate for the term closest to what is left on your existing mortgage. Check whether your lender will round up or down when choosing the nearest term. | |
| Step 3: Subtract the answer identified in step 2 from the answer identified in step 1 to get the difference in interest rates. (Write this interest rate as a decimal. For example, 4% = 0.04) |
|
| Step 4: Multiply this answer by the outstanding balance on your mortgage. | |
| Step 5: Divide this answer by 12 months in a year to get the monthly interest differential. | |
| Step 6: Multiply this answer by the number of months left on your term. Check whether your lender will round up or down to the nearest month. | |
| Prepayment charge estimate based on interest rate differential: |
Example of prepayment charge calculations
Jim wants to break his mortgage and take out a new mortgage contract to take advantage of the lower interest rates currently being offered. He wants to know how much he would be charged to do so.
Jim’s mortgage contract states that he will need to pay the greater of either three months’ interest or the interest rate differential. Jim can estimate how much this charge will cost him using the tables below.
- Outstanding mortgage balance: $200,000
- Annual interest rate: 6%
- Number of months left in term: 36 months (or three years) left in a five-year term
- Today’s interest rate for a term of the same length: Jim’s lender is offering a 4% interest rate for a mortgage with a 36-month term
a) Three months’ interest
| Step 1: Identify the outstanding balance on Jim’s mortgage. | $200,000 |
| Step 2: Multiply the outstanding balance on Jim’s mortgage by the annual interest rate on his mortgage. (Write the annual interest rate as a decimal. For example, 6% = 0.06) |
$200,000 x 0.06 = $12,000 |
| Step 3: Divide the answer by 12 months in a year to get the monthly interest payable. | $12,000 ÷ 12 = $1,000 |
| Step 4: Multiply the answer by 3 months. | $1,000 x 3 = $3,000 |
| Prepayment charge estimate based on three months’ interest: | $3,000 |
This example uses a simplified method to calculate the interest rate differential for demonstration purposes. Review your mortgage agreement or contract to find out exactly how your charge will be calculated.
The interest rate differential charge is estimated as follows:
| Step 1: Identify the annual interest rate on Jim’s mortgage. | 6% |
| Step 2: Identify the current interest rate for the term closest to what is left on Jim’s existing mortgage. | 4% |
| Step 3: Subtract the answer identified in step 2 from the answer identified in step 1 to get the difference in interest rates. (Write this interest rate as a decimal. For example, 2% = 0.02) |
6% – 4% = 2% = 0.02 |
| Step 4: Multiply this answer by the outstanding balance on Jim’s mortgage. | 0.02 x $200,000 = $4,000 |
| Step 5: Divide this answer by 12 months in a year to get the monthly interest differential. | $4,000 ÷ 12 = $333.33 |
| Step 6: Multiply this answer by the number of months left on Jim’s term. | $333.33 x 36 = $12,000 |
| Prepayment charge estimate based on interest rate differential: | $12,000 |
If Jim decided to break his mortgage:
- His prepayment charge would be based on the interest rate differential, since that amount is greater than three months’ interest. The prepayment charge is estimated to be $12,000.
If your lender is a federally regulated financial institution, such as a bank, it must outline prepayment privileges and charges, along with other key details, in an information box at the beginning of your mortgage agreement.
By law, it must tell you how the prepayment charge will be calculated. It must also provide you with a description of the components used in the calculation of the charge. This information must be presented in a manner and written in language that is clear, simple and not misleading.
If the calculation is complex, your lender may provide a simplified example, illustration or method to help you estimate the prepayment charge.
Read your mortgage contract carefully to confirm these details before you sign. Ask the financial institution about anything you don’t understand.
For tips on how you can reduce the prepayment charge, read Renewing and Renegotiating Your Mortgage.
Notes
Present value: A present value formula calculates the value of future payments in today’s dollars.