For many Canadians, buying a home is one of the biggest investments they will make in their lifetime. With that comes a mortgage, and the responsibility of paying it off over a period of time. But what happens if you want to pay off your mortgage early? Many lenders in Canada charge prepayment penalties for doing so, and these penalties can be quite significant. In this blog, we’ll take a closer look at Canadian mortgage prepayment penalties and what you need to know.
What are prepayment penalties?
Prepayment penalties are fees that a lender charges a borrower for paying off their mortgage before the end of the term. Essentially, they are a way for the lender to recover the interest that they would have earned over the remaining term of the mortgage. In Canada, prepayment penalties are often calculated based on the greater of three months’ interest or the interest rate differential (IRD).
Three Months’ Interest
This is a simple method of calculating the prepayment penalty. It is calculated by multiplying the borrower’s current mortgage interest rate by the outstanding mortgage balance and then multiplying that result by three months. For example, if you have a mortgage with a balance of $300,000 and an interest rate of 2.5%, the penalty would be $1,875 (2.5% x $300,000 x 3/12).
Interest Rate Differential (IRD)
The IRD method is a bit more complex. It is calculated by determining the difference between the interest rate on the mortgage and the interest rate on a comparable mortgage product with the same term as the remaining term on the borrower’s mortgage. This difference is then multiplied by the outstanding mortgage balance and the remaining term of the mortgage. For example, if you have a mortgage with a balance of $300,000 and an interest rate of 2.5% with three years remaining on the term, and the current interest rate on a comparable product is 2%, the penalty would be $9,000 (0.5% x $300,000 x 3).
Exceptions to Prepayment Penalties
It’s important to note that not all mortgages have prepayment penalties. Some lenders offer open mortgages, which allow borrowers to pay off their mortgage at any time without penalty. However, open mortgages often have higher interest rates than closed mortgages, which means that they may not be the best option for all borrowers.
It’s also worth noting that prepayment penalties may be waived or reduced under certain circumstances. For example, if you are selling your home and buying a new one, your lender may allow you to transfer your mortgage to the new property without penalty. Additionally, some lenders allow borrowers to make prepayments without penalty, up to a certain percentage of the outstanding balance.
Conclusion
Mortgage prepayment penalties are an important consideration for anyone who is considering paying off their mortgage early. They can be a significant expense, so it’s important to understand how they are calculated and what your options are for reducing or avoiding them. If you’re considering paying off your mortgage early, it’s a good idea to speak with your lender to understand what your prepayment penalty would be and to explore your options for reducing or avoiding it.