Stay Out of the Penalty Box

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Mortgage rates can be so tedious, just read about the rate debate. We can forget that at the end of the day, once the terms have been decided, a mortgage is a contract.

Contracts are legal agreements with consequences, or penalties if the contract is broken. It is something that every homeowner agrees to when signing the mortgage but can be easily forgotten- until you must pay the price.

Why would you break your mortgage?

Life happens, and situations change causing you to rethink your mortgage.

You might be surprised to find out that 6 out of 10 mortgages in Canada are broken within 3 years. There are typically nine common reasons that this happens:

  • Sale and purchase of a new home
  • To utilize the equity
  • To pay off debt
  • Cohabitation, marriage and/or children
  • Divorce or separation
  • Major life events (illness, unemployment, death of a partner)
  • Removing someone from the title
  • To get a lower interest rate
  • To pay off the mortgage

You can’t always predict the future, but you still have a mortgage. If planning on breaking your mortgage, you must understand what steps need to be taken for things to go smoothly.

The mortgage industry is a competitive one and you don’t want to be lost in the details.

Step 1: Calculate the Penalty

Typically, the penalty for breaking a mortgage is calculated in one of two ways. Lenders generally use either an Interest Rate Differential calculation or the sum of 3 months’ interest to determine the penalty.

You will typically be assessed the greater of the two penalties unless your contract states otherwise.

Interest Rate Differential (IRD)

In Canada, there is no one-size-fits-all rule for how the Interest Rate Differential (IRD) is calculated and it can vary greatly from lender to lender.

However, typically the IRD is firstly based on the amount remaining on the loan. In addition, it is also dependent on the difference between the original mortgage interest rate you signed and the current rate the lender offers.

Confused?

Let’s assume you have a balance of $200,000 on your mortgage, an annual interest rate of 6%, 36 months remaining in your 5-year term and the current rate is 4%. This would mean an IRD penalty of $12,000 if you break the contract.

Ideally, you will want to be aware of what your IRD penalty would be before you decide to break your mortgage as it is not always the most viable option.

3 Month Difference

IRD is not always the case. In some mortgages, the penalty for breaking your mortgage is simply equivalent to three months of interest.

Using the same example as above – a balance of $200,000 on your mortgage, an annual interest rate of 6% – then three months of interest would be a $3,000 penalty. A variable-rate mortgage is typically accompanied by only a three-month interest penalty.

Step 2: Pay the Penalty

When it comes to making the payment, some lenders may allow you to add this penalty to your new mortgage balance (meaning you would pay interest on it). However, you can also pay your penalty upfront.

A Broker’s Advice

Whenever possible, if you can wait out your current mortgage term before making a change to your mortgage, avoid being stuck in the penalty box. You don’t want to miss out on opportunities in the future.

If you cannot avoid a penalty, do note that, while only calculators can be great tools for estimates, it is best to call your lender or mortgage broker directly for the accurate number in the case of determining penalties.

If you are unsure about getting the best penalty terms, contact us today! We promise we can get you through the process as smoothly as possible.

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