BREAKING YOUR MORTGAGE EARLY
You never plan for it but it happens.
Most people don’t plan on breaking their mortgage early. After all, there are terms shorter than 5 years available from almost every lender. However there are times when it’s either advantageous to break your mortgage before its maturity date, or it just can’t be avoided. But what happens if you do need to get out of a mortgage contract early?
In the fine print of every mortgage contract, there are provisions for what will happen should the borrower want to pay out the entirety of the loan before the designated maturity date, whether you’re paying it out because you’ve sold the property, or because you’re switching to another lender.
With the exception of open term mortgages, which can be paid out in full at any time, there are pre-payment penalties for breaking early. The rationale for this is that when you obtain a mortgage, you are committing to the lender that you will pay a certain amount of interest over the term that you’ve chosen. If a lender lets you out of that contract early, they are losing those interest payments for the remainder of the term. To compensate, they charge a pre-payment penalty.
The way the penalty is calculated depends both on the kind of mortgage you have and the length of time left in your term, but there are two basic kinds: 3 month’s interest or interest rate differential (IRD). The 3 month’s interest penalty is fairly straightforward. You’re simply paying the amount of interest you would have paid over the next three months if you hadn’t broken the mortgage early. The IRD calculation is a little more complex, and varies somewhat from lender to lender. It’s based on the balance of your mortgage and the difference between your current interest rate and the interest rate the lender could charge if it were to re-lend that money for the remainder of your term. The part that can get tricky is whether a lender uses its posted rates (typically higher than it would actually lend at) or its discounted rates for comparison. Using the posted rates results in higher penalties, so it’s good to know how your lender will make the calculation going in.
So how do you know if you’ll be looking at a 3 month’s interest penalty or an IRD? Well, if you’re in a fixed rate mortgage, you’ll be charged whichever is higher (and IRDs are almost always higher in a declining interest rate market). However, if you signed up for a fixed rate term of longer than 5 years, once that 5 year anniversary has passed the lender can’t charge an IRD and must instead use the 3 month’s interest calculation. The same rule applies to variable rate mortgages of any term length. Some lenders may also charge an administration fee on a variable rate mortgage.
Mortgage pre-payment penalties can get costly if you wind up breaking your mortgage early and there are a small number of lenders who prohibit breaking a mortgage early. If you’re at all unsure of whether you’ll stay in your home over the length of the term, it’s worth it to consider how the penalties will be calculated, or to look at going with a shorter term or even a variable rate to avoid extra costs. Your mortgage broker can help you make the comparisons and save you money and frustration down the road. Give us a call if you have any questions – we love chatting about this stuff. No, really!