Flexibility is an essential factor in homeownership. Life is full of unexpected events and circumstances, such as relocating for a new position or refinancing to benefit from lower rates. In these cases, you may need to terminate your mortgage agreement sooner than required. However, before you choose to do it you should consider the potential outcome scenarios such as having mortgage penalties depending on the mortgage type and conditions of your contract.
Let’s discuss the essential factors you should be aware of regarding mortgage penalties in Canada so that you can make informed decisions.
Mortgage Penalties in Canada
If you decide to end your mortgage contract sooner than it was meant to finish you may end up paying a penalty. Your mortgage lender loses out on the interest they would have received if you had remained with them to the end of your term because they promised to loan you money for a set period. The penalty’s sole purpose is to compensate the lender for the loss.
Why You Might Break Your Mortgage Contract
There are several reasons why you might decide to break your mortgage contract, including:
- Interest rates have dropped, and you wish to refinance at a better rate.
- Changes in your financial situation, such as a significant increase or decrease in income.
- Plans to move to a new home, which requires breaking the current mortgage.
- Family changes, like growing your family or needing to downsize.
- Your current home no longer meets your needs, and you want to explore new options.
Types of Mortgages and Their Penalties
There are two primary types of mortgages in Canada: fixed-rate mortgages and variable-rate mortgages. Each comes with different penalty calculations:
- Fixed-Rate Mortgages
With this type of mortgage, your mortgage interest rate remains the same over the term of the mortgage. Early termination of a fixed-rate mortgage contract might result in significant fines. The reasons is simple the lender loses the amount of future interest payments that were agreed beforehand.
The penalty for breaking a fixed-rate mortgage is typically calculated as the greater of two amounts:
- Three months’ interest: This is a straightforward calculation where you pay three months’ worth of interest on your current mortgage balance. This is usually the penalty for breaking a mortgage early, but it can sometimes be higher depending on market conditions.
- Interest Rate Differential (IRD): The IRD is calculated based on the difference between the interest rate on your current mortgage and the current market rate for a mortgage with a similar term. This is a more complex calculation and could result in a higher penalty, particularly if interest rates have dropped since you signed your mortgage.
For instance, the lender may compute the IRD to compensate for missed interest if you owe $300,000 on a fixed-rate mortgage with an interest rate of 3.5% and the current market rates for a comparable term are 2.0%.
- Variable-Rate Mortgages
Variable-rate mortgages are tied to the prime lending rate and fluctuate with changes in interest rates. If you have a variable-rate mortgage and you decide to break it, the penalty is usually lower than that of a fixed-rate mortgage. It’s often calculated as three months’ interest, which is generally a smaller amount compared to the IRD calculation for fixed-rate mortgages.
However, keep in mind that if your mortgage is variable but has a fixed payment plan (i.e., your payment amount remains the same even when interest rates change), your lender might still apply a penalty based on market conditions.
The Costs of Breaking Your Mortgage Contract
You may be subject to a prepayment penalty if you terminate your mortgage early. Whether your mortgage is closed or open has a significant impact on how much this penalty will cost.
- Open Mortgages
Open mortgages are more flexible and allow you to break the contract or pay off the mortgage early without facing a penalty. This flexibility makes them a great option if you anticipate needing to make changes to your mortgage in the future.
- Closed Mortgages
Closed mortgages, on the other hand, typically come with higher penalties for early termination. The penalty for breaking a closed mortgage usually includes:
- Prepayment penalties: This is the main cost associated with breaking your contract early.
- Administrative fees: Some lenders charge for processing the early termination of the mortgage.
- Appraisal fees: These might apply if the lender requires an appraisal to assess the current value of your property.
- Reinvestment fees: Lenders may charge a fee if they need to reinvest the funds in a new mortgage.
- Mortgage discharge fees: This fee is applied to remove the existing mortgage charge from your property and register a new one with the lender.
Other Factors That Affect Penalties
While the type of mortgage is a major factor in calculating penalties, several other factors can influence the amount you’ll have to pay:
- Prepayment Privileges
Many mortgages in Canada offer prepayment privileges that allow you to pay off a portion of your mortgage early without incurring penalties. Typically, this means you can make lump-sum payments up to a certain percentage of your original mortgage balance each year (usually between 10% and 20%) or increase your monthly payments. If you are simply paying down your mortgage ahead of schedule rather than breaking the contract, you may avoid a large penalty altogether.
- Mortgage Renewal or Transfer
If you’re simply transferring your mortgage to another lender at the end of your term or renewing with your current lender, there may be no penalty at all. However, if you transfer your mortgage before the term ends, penalties will likely apply.
- Porting Your Mortgage
Some mortgages in Canada offer a feature called porting, which allows you to transfer your mortgage to a new property without incurring a penalty, provided you meet certain conditions. Porting can be a good option if you plan to move and want to keep your current mortgage terms.
Mitigating Mortgage Penalties
While breaking your mortgage early may seem like a great option, the penalties can be steep. Here are a few strategies to help mitigate the impact of penalties:
- Consider Timing: Mortgage penalties are often more favourable when you break the mortgage closer to the end of your term, as there is less time for the lender to lose out on interest payments. If you can wait, it might be worth it to break your mortgage closer to its maturity date.
- Refinance with the Same Lender: If you’re looking to refinance to take advantage of lower rates, consider doing so with your current lender. They may offer better terms or be more flexible on penalty fees.
- Negotiate: In some cases, you may be able to negotiate the penalty with your lender, especially if you’re refinancing or taking out another product with them.
- Shop Around for Better Deals: Sometimes, moving your mortgage to a new lender can be worth the penalty costs, especially if the new rate is significantly better. Make sure to calculate the total costs of switching before making a decision.
Breaking your mortgage in Canada is a decision that shouldn’t be taken lightly, especially when penalties are involved. Whether you’re relocating, refinancing, or paying off your mortgage early, it’s essential to understand the financial consequences and the type of mortgage you have. By weighing your options carefully, consulting with your lender, and potentially exploring prepayment privileges or porting, you can minimize penalties and make the best choice for your financial future.
Before making any final decisions, always take the time to review the terms of your mortgage agreement and, if necessary, consult a mortgage broker or financial advisor to help you navigate this complex process.
