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What will it cost to end my mortgage early?

I get asked all the time by clients, Realtors, referral partners and even other mortgage brokers: how much does it cost to end a mortgage term early?  (My family and I), (my client), (my friend), (my mom), (my dentist) have signed up for a 5-year term and need/ want to sell; how much will it cost to get out of it? 

Over half of all mortgages in Canada are ended early with some stats showing that number approaching 70%.  People move, jobs change, owners cash out; life happens.  “Uncertainty is the only certainty there is…”  The 2015 Ombudsman for Banking Services and Investment (OSBI) Annual Report ranked mortgage prepayments penalties as the second most contentious banking issue in Canada right after fraud.  So OSBI’s data shows people complain to them about criminals assuming their identities and draining their savings accounts only slightly more than the penalty that accompanies leaving their mortgage early?  Yes…  Heady stuff.

So how much does it cost?  Well the answer is…  There is no definitive answer.  Lenders charge for what they call “prepayment penalties” in 2 different ways:  a 3-Month Interest penalty or an Interest Rate Differential (IRD) penalty.

  • 3-month interest penalty.  They ding you for the amount of profit they would have made in 3 months off of your mortgage.  It’s not a full 3 months of mortgage payments, only the interest portion, not the part that would have paid down your principal.  You will not find this formula at any of the Big Five banks, but some “monoline” lenders, those whose only business is mortgages, attempt to differentiate themselves by offering this approach. 
     
  • 3-month interest or Interest Rate Differential penalty, whichever is larger.  This is the most common method used by both the Big Five banks and monoline lenders.  They will use scenario #1 above when it suits them, ie they make more money, or they will use an IRD penalty when it earns them more which is often the case.

 

  1. Big Bank IRD penalty.  We must break the IRD down further because of the way big banks calculate it versus monoline lenders.  Both use, as the name indicates, a change in the interest rate to calculate their prepayment penalty, but the Big Banks add a further wrinkle to the equation.  Have you ever noticed that the rate on their website is way, way higher than the industry best or even what they would end up giving you if you sat down with them?  I will calculate below the prepayment penalty for a mortgage that is broken after 2 years on a 5-year mortgage term at 2.79% fixed.

Mortgage

$500,000

Approved interest rate

2.79%

Posted interest rate at approval

4.74%

Total discount given at approval

1.95%

Current posted 3-year interest rate

3.79%

Remaining mortgage term

3 years

You take the amount of the mortgage outstanding, $500,000, and multiply it by the approved interest rate, 2.79% minus the current posted 3-year interest rate, 3.39% minus the discount at approval, 2.05% and multiply all that by the remaining mortgage term, 3 years.

$500,000  X  [2.79% – (3.79% - 1.95%)]  X 3 = $14,250

 

  1. Monoline IRD penalty.  Similar to the Big Bank IRP except that you don’t calculate any discount from some fictional “posted rate” that no one ever actually pays.  I will calculate below the prepayment penalty for the same mortgage, also broken after 2 years on a 5-year mortgage term at 2.79% fixed.

Mortgage

$500,000

Approved 5- year interest rate

2.79%

Current 3-year interest rate

2.49%

Difference in approved vs. current

.30%

Remaining mortgage term

3 years

 

You take the amount of the mortgage outstanding, $500,000, and multiply it by the difference in the approved rate vs. the current 3-year rate, .30%, then multiply by the remaining mortgage term, 3 years.

$500,000  X  .30% (or .0030)  X  3 = $4,500

 

  1. 3-Month Interest penalty.  For $500,000 at 2.79% fixed for 5 years your mortgage payment would be $2,312 per month.  Depending on which period you are in, as the proportion of interest to principal paid lowers as they outstanding amount lowers, will determine how much your penalty is.  The first payment is $1,175 to the principal and $1,137 for interest so we will use it and multiply it by 3 = $3,411  

 

The best case scenario is that you need to sell and plan to buy a new home right away, your mortgage broker had the foresight to choose a portable mortgage product for you, one that can be transferred from property to property, and you can simply “port” the existing mortgage over to the new property.  Some lawyer fees to switch the title, some paperwork if the value of the new home is higher or lower and you’re done.  The worst case scenario is that you want to sell and don’t plan on buying right away.  That’s when one of the scenarios above comes into play.  As you can see from the calculations above the Big Bank IRD penalty is $14,250, the monoline IRD penalty is $4,500 and the 3-month interest penalty would be around $3,411. Some hefty variances and something to keep in mind when selecting your next mortgage!

 

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