Understanding the penalty to payout your mortgage is often confusing, frustrating and plain old expensive. For the next few blog posts I hope to shed some light on better understanding how penalties are calculated, why they can be expensive, and what you should know as a mortgage consumer to avoid any surprises.
There is no required consistency in Canada when it comes to how a lender calculates their mortgage penalties. Most lenders charge an early payoff penalty on closed mortgages (both fixed rate and variable rate) if the mortgage is paid in full (or paid out to be transferred to another lender) prior to the end of the mortgage term.
The only mortgage that does not have any pre-payment penalties in an Open Mortgage. Since you are able to pay off your mortgage at anytime the lender changes a premium rate. This rate will be higher than either a Closed Variable Rate Mortgage or a Closed Fixed Rate Mortgage.
The Mortgage Lender, or Bank, must describe the penalty they charge on the mortgage documents when you sign your Mortgage Contract.
Typically, the wording you will see will be something of this nature…
The Mortgage penalty will be the greater of three months interest penalty OR the interest rate differential (IRD).
In other words, whichever amount is the LARGER of these2 figures will be your penalty.
For this blog post, we are going to look at the 3-month interest penalty.
The 3-month interest penalty is based on 3 months simple interest at your current mortgage rate, on the principal amount owing on the repayment date.
Let’s look at an example:
Mortgage value of $250,000 @ 5% Interest = $12,500 (annual interest amount)
Divided by 12 (12 months in a year) = $1,041.67/month.
So 3 months is simply $1,041.67 x 3 = $3,125.01
Almost all Variable Rate Mortgages in Canada use the 3 months interest penalty calculation. Some Variable Rate Mortgages will use a declining calculation. For instance, after year 3 of your mortgage (assuming a 5-year term) the lender will only charge 2 months interest. Clauses like this however is not the norm.
It’s always best to make sure you understand what penalties you will face if you have to payout your mortgage before the agreed upon term, whether it’s because you are moving, refinancing, or simply paying off your mortgage.