Your mortgage is a long financial commitment. It makes sense to want to get rid of it as soon as possible. But if you pay off your mortgage early, your lender loses out on the interest on that debt. That’s why borrowers often have to pay a prepayment penalty when you pay down more of the mortgage than is permitted in your mortgage contract, or pay out the mortgage outright.
You may have some prepayment privileges in your mortgage agreement. Most lenders typically allow you to make annual lump sum payments of 10% to 20% and increase your monthly payments by the same amount. Your rights depend on the flexibility of the contract. Here’s what to think about — plus a handy calculator to help you determine what kind of penalty you might face.
What is the Difference Between Open and Closed Mortgages?
Typically, a closed mortgage can be locked in at a lower interest rate, but you can’t make additional payments outside of what is contractually permitted. An open mortgage, on the other hand, allows you more flexibility to repay the debt whenever you like, but often entails higher interest rates.
As mentioned above, certain lenders allow you to make extra payments or accelerate the payment schedule up to a certain amount. These are called prepayment privileges. If you use up your prepayment privileges on an annual basis, you reduce the amount owed on your mortgage without penalty. Also, if you incur a prepayment penalty later on, it will be based on a lower mortgage balance.
You can find the prepayment details for your mortgage in your contract, but it’s also important to understand the different mortgage options you have when you start your mortgage search.
When Do Prepayment Penalties Apply?
The details of prepayment penalties vary from lender to lender. Here are some common cases where you may face a fee, such as when you:
- Transfer your mortgage to another bank or lender
- Break your mortgage contract (for example, replace the mortgage with a new one)
- Pay more than your prepayment privileges
- Borrow more using the equity in your home
You may have to pay the fee upfront, or it may be added at the end of the mortgage term. If it’s the latter, you’ll have to pay interest on the penalty.
If you do break your contract, you may also have to pay an administration fee and other charges in addition to the prepayment amount. Always make sure you’re aware of all the costs involved before considering breaking your mortgage.
How Are Prepayment Penalties Calculated?
Your lender has the option to set the calculation of the prepayment penalty. Normally, it is the higher of two calculations: three months’ interest on your outstanding balance, or a formula called the interest rate differential (IRD). The interest rate differential is the difference between your existing mortgage interest rate, and today’s available rate for the term you have remaining.
A handy Mortgage Penalty Calculator can help you determine the possible costs.
How Can I Avoid Prepayment Penalties?
If you are buying a new home, you may be able to take your existing mortgage with you. This is called porting your mortgage. If your lender allows this, your current mortgage stays in place and you do not have to pay a prepayment penalty.
Should I Switch Lenders?
If you’re shopping for a mortgage rate, be sure to do your research ahead of time so you understand your costs of switching. Your mortgage is one of your most important financial commitments, so it pays to be informed.