Your mortgage is a contract for the length of your term (see Term vs amortization). If you end it early, the lender usually charges a fee to make up for the interest it won't get. That fee is the prepayment penalty.
1. When you pay a penalty
Your lender may charge one if you1:
- Pay off more than your mortgage allows each year.
- Break your mortgage contract.
- Move your mortgage to another lender before your term ends.
- Pay off the whole mortgage early, including when you sell your home.
An open mortgage lets you pay it off at any time without a penalty1. Most mortgages are closed, which is why this matters.
2. The two ways it's worked out
The penalty is usually the higher of two amounts1:
- Three months' interest on what you still owe.
- The interest rate differential (IRD). This is the gap between the interest you'd pay at your rate for the rest of your term and the interest at a lower comparison rate.
Lenders usually use the IRD when your rate is higher than today's rates and you signed less than five years ago1. When rates have dropped since you signed, the IRD is usually the bigger one.
3. A worked example
You owe $200,000 at 6%, with 36 months left in your term. The lender's posted rate for a similar term is now 4%1.
- Three months' interest: $200,000 × 6% ÷ 4 = about $3,000.
- IRD: the 2-point gap between 6% and 4%, for 3 years, on $200,000 = about $12,000.
- You pay the higher one: about $12,000, maybe plus an administration fee1.
4. Why lenders' numbers differ
The IRD depends on which rate your lender compares yours with. Some compare it with today's posted rate for a similar term. Others take today's posted rate and subtract the discount you got when you signed1. That makes the comparison rate lower and the gap bigger, so the same mortgage can cost much more to break at one lender than at another.
Posted rates are the rates lenders advertise as standard. A rate below the posted rate is a discounted rate, and most people get one1. Ask how your lender treats your discount before you sign, not just when you leave.
5. What your lender must tell you
Banks and other federally regulated lenders must:
- Show your prepayment privileges and penalties in an information box at the start of your agreement1.
- Explain how they work out the penalty, and what can make it change over time12.
- Have a penalty calculator on their website2.
- Give you a toll-free number to reach staff who know about prepayments. They can tell you the actual penalty, and give it to you in writing if you ask2.
6. Ways to keep the cost down
- Use your prepayment room. Paying down what you're allowed each year lowers what you owe, and unused room usually doesn't carry over to the next year. Some lenders limit prepayments just before you break the mortgage, so check first1.
- Take it with you. If you're moving, ask whether you can port your mortgage: take your rate and terms to the new home1.
- Wait if you can. If the penalty is big, it may be cheaper to wait until your term ends1.
- Shop around at renewal. There's no penalty to switch when your term is up, so that's the time to compare lenders and brokers1. See Renewing your mortgage.
- Get it in writing. Ask your lender for the exact penalty, as a written statement, before you decide anything2.
7. Other costs when you leave
Besides the penalty, you may pay an administration fee1. If you're switching lenders, there can also be a discharge or transfer fee, an appraisal and legal costs. Renewing your mortgage covers those.
Try it. The penalty calculator estimates both amounts for your mortgage, and shows which one you'd pay.
Thinking of leaving early? The mortgage renewal workbook has a worksheet to estimate your penalty step by step, plus a grid to compare offers.