How is a prepayment penalty calculated?

Most lenders charge the greater of three months' interest on your balance or an interest-rate differential. The IRD compares your contract rate to the lender's current rate for a comparable remaining term.

Can I avoid a prepayment penalty?

Yes, by staying within your annual prepayment privileges, choosing an open mortgage, porting your mortgage to a new home, or waiting until renewal when you can repay or switch without penalty.

Do variable-rate mortgages have lower penalties?

Often, yes. Variable-rate mortgages usually use the three-months-interest formula, which is typically much smaller than the IRD penalty common on fixed-rate mortgages.

Mortgage Glossary

What is Prepayment Penalty?

A prepayment penalty is a fee a lender charges when you pay off or pay down a closed mortgage beyond your allowed privileges, or break it before the term ends. It is usually the greater of three months' interest or an interest-rate differential (IRD) calculation. Open mortgages have no prepayment penalty.

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Quick answer

Also known as: breakage cost, prepayment charge

Key points

Charged for breaking a closed mortgage or prepaying beyond your privileges.
Usually the greater of three months' interest or the interest-rate differential.
IRD penalties on fixed-rate mortgages can run into the tens of thousands.
Variable-rate mortgages typically use the simpler three-months-interest charge.
Open mortgages carry no prepayment penalty at all.

Prepayment Penalty explained

A prepayment penalty, sometimes called a breakage cost, compensates the lender for interest it loses when you repay a closed mortgage early. It typically applies when you break the mortgage to sell, refinance, or switch lenders, or when you prepay more than your annual privileges permit. The charge is most often the greater of two formulas: three months' interest on the balance, or an interest-rate differential.

The interest-rate differential, or IRD, estimates the interest the lender would miss out on by comparing your original rate to the rate it could now charge for the remaining term. On a fixed-rate mortgage with a high original rate and a long remaining term, an IRD penalty can be substantial, sometimes tens of thousands of dollars. Variable-rate mortgages usually use the simpler three-months-interest charge.

What a Prepayment Penalty is for

The penalty exists to protect the lender's expected interest income over the agreed term. When you commit to a closed mortgage at a set rate, the lender prices it assuming it will earn that interest for the full term. The penalty recovers some of that income if you exit early, which is why closed mortgages offer lower rates than open ones in the first place.

How it can help you

Understanding prepayment penalties helps you avoid a nasty surprise when selling or refinancing, and lets you weigh whether breaking your mortgage to chase a lower rate actually pays off after the charge. Penalty calculation methods, especially how lenders compute IRD, vary a lot and can mean thousands of dollars difference. Lenderoo lets you compare lenders and their penalty terms across 40+ lenders for free so you can choose a mortgage whose breakage rules suit your plans.

When it comes up

A homeowner three years into a five-year fixed mortgage wants to refinance to a lower rate. Before deciding, they ask their lender for the exact penalty. The IRD comes to $9,000. They compare that cost against the interest they would save at the new rate to decide whether breaking the mortgage is worth it.

Example: three months' interest versus IRD

You have a $300,000 balance. The three-months-interest penalty at roughly 5% would be about $3,750.

The IRD compares your 5% rate to a current rate of, say, 3% over your remaining two years. Roughly, a 2% gap on $300,000 for two years works out to around $12,000. The lender charges the greater of the two, so you would pay the $12,000 IRD, not the $3,750. This is why breaking a fixed mortgage early can be far more costly than people expect.

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Questions & answers

Prepayment Penalty: frequently asked questions

Common questions Canadians ask about prepayment penalty.

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