Mortgage Penalty Charges
Jarek Bucholc

Mortgage Penalty Charges

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Jarek Bucholc  
 

If you are locked into a closed mortgage, you may want to break your current mortgage contract and negotiate a new mortgage at a lower rate. Some agreements do not allow for a mortgage to be renegotiated, but most do. Financial institutions will usually allow you to pre-pay your mortgage in full, but will add a penalty.


 

How penalty charges are calculated

Your penalty charges depend on what was stated in the original mortgage agreement or in the most recent renewal agreement that you signed.

If your agreement allows you to pay off or renegotiate your mortgage early, you will normally have to pay a penalty.

The penalty is generally the greater of:

a) three month's interest on your current mortgage, calculated as follows:

A  ×  
             B              
12 months in a year
  ×  3 months
A is the outstanding amount on your mortgage
B is the annual interest rate on your mortgage

b) the interest rate differential which can be calculated as follows:

A  ×  
          B  -  C          
12 months in a year
  ×  D

A is the outstanding amount on your mortgage
B is the annual interest rate on your mortgage
C is the current mortgage rate for a term similar to what is left on your existing mortgage
D is the number of months left to the end of your term

(Note: This example is a simplified method for calculating the interest rate differential. Some financial institutions calculate the penalty differently. You should check with your own financial institution for information on the method of calculation it uses.)

If you initially received a discounted rate, the financial institution may apply this discount to your current mortgage rate. On the other hand, if you received a "cash back" instead of a discounted rate, the financial institution may ask you to reimburse a portion (or all) of the cash back you initially received.

Some financial institutions may also add an administration fee if you pay your mortgage off early or if you renegotiate your mortgage. This fee may be paid by the institution to which you are transferring your mortgage.

Example: Penalty calculation

Jim started with a mortgage of $100,000, at an annual interest rate of 8 per cent. He has 36 months left in his 60-month (five-year) term. His outstanding balance is $97,218. Jim wants to break his mortgage and take out a new mortgage contract, to benefit from the lower interest rates currently being offered. He wants to know what penalty he would pay for doing so. Assuming that the current market mortgage rate for a 36-month (or three-year) period is 6 per cent, Jim would pay a penalty based on the higher of the two amounts shown below (because this is what his mortgage contract stipulates).

Possible penalty options (simplified for illustration purposes)

a) Three months' interest penalty

The penalty would be:

Outstanding balance × Monthly interest rate of Jim's mortgage × 3 months

This would amount to:

$97,218 × (8% ÷ 12 months) × 3 months
= $1,944

b) Interest rate differential penalty (based on the difference in interest rates)

To obtain the interest rate differential, take the interest rate on Jim's mortgage (8%), minus the current market mortgage rate (6%): 8% - 6% = 2% (interest rate differential).

The interest rate differential penalty would be:

Outstanding balance × Monthly interest rate differential × Number of months remaining on Jim's mortgage

This would amount to:

$97,218 × (2% ÷ 12 months) × 36 months
= $5,833

If Jim decided to break his mortgage, he would have to pay a penalty of $5,833, since this is the higher of the two penalty calculations.

This example uses a simplified method to calculate the interest rate differential for demonstration purposes. Ask your financial institution to provide the exact cost of paying off a mortgage before the maturity date.


Tips to minimize penalty charges

If you decide to break your mortgage to benefit from lower interest rates, you might be able to minimize the amount of penalty charges you have to pay. Keep in mind, however, that your lending institution may not offer this option. Look at your mortgage agreement to see what options are available to you or contact your branch.

Making a lump sum payment before renegotiating

Many mortgage agreements offer a pre-payment option without penalty, which may allow you to pay up to 20 per cent, and sometimes even more, of your mortgage off in any given year. If it is possible to do so, you may want to pay a portion of your mortgage (if your financial institution allows this) before you renegotiate it. Your penalty would then be calculated on the outstanding balance after you have made your pre-payment.

In the preceding example, if Jim had made a lump-sum payment of $5,000 before breaking his mortgage, his penalty would have been calculated on an outstanding balance of $92,218, instead of $97,218, and his penalty would have been $5,533, rather than $5,833.


Blend-and-extend option

Some institutions also allow you to extend the length of your mortgage prior to your mortgage renewal date, to take advantage of the current low rates by creating a new blended rate and longer-term mortgage. This is called the "blend-and-extend" early renewal option. Not all financial institutions offer this option, and different institutions have different ways of calculating this option. The following example gives you an idea of one common method of calculating the blend-and-extend option.

Example: Blend-and-extend option

Linda has 12 months left in her 60-month (five-year) mortgage, at an interest rate of 8 per cent. Let's assume that the current five-year mortgage rate is 6 per cent. If Linda decided to extend her mortgage before its term ended and take on another five-year mortgage, her new mortgage rate, using the blend-and-extend option, would be as follows:

A  +  B
C

A is (8% x 12 remaining months in current term) = 0.96
B is (6% x 48 months of new term) = 2.88
C is 60 months (new term)

  
0.96  +  2.88
60
  =  6.4%


If Linda chooses the blend-and-extend option, her mortgage rate will be 6.4 per cent for the next 60 months, and she will not have to pay a penalty to benefit from the lower rate. (Note: Your financial institution may add an administrative fee.)

It may be beneficial for Linda to choose the blend-and-extend option if she believes that interest rates will increase substantially before the end of the term of her mortgage and wants to lock in now.

The preceding method of calculating the blended rate has been simplified for illustration purposes. The formulas used by financial institutions are generally based on net present value; therefore, your actual blended rate will be different (it is usually higher). Contact your financial institution for the exact blended rate.


Things to remember when you switch institutions

  • A penalty may apply if you wish to switch institutions before the end of your mortgage term.
  • You may have to pay legal fees to discharge the old mortgage and register the new mortgage.
  • Other administration fees may also apply.
  • Don't hesitate to ask the lending institution whether it is willing to pay part or all of these fees.
  • If not, ask yourself if the savings of going to a new institution are greater than the cost of switching.
  • Your new prepayment privileges will not be based on the original amount of your mortgage, but on the amount of the mortgage balance transferred to the other financial institution.

Source: FCAC
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