A mortgage penalty is the fee you pay if your break your mortgage contract early. This mortgage breakage penalty is intended to compensate for the lender’s lost revenue.
Reasons for breaking a mortgage
Breaking a mortgage is not uncommon in Canada. The Canadian Association of Accredited Mortgage Professionals reports that 9 per cent of Canadians choose to refinance their mortgages before their term is up. Switching mortgages for a better rate is one of the most common reasons Canadians break their mortgages, though selling your home during your mortgage term will also incur this penalty.
Before you consider breaking your mortgage, make sure you know what your penalty will be. In some instances, this penalty will be greater than the money you save with better mortgage rates. Some mortgages stipulate that you cannot break the mortgage unless you sell, so you will be unable to switch lenders at any time without paying the mortgage penalty.
It’s therefore essential that you consider all possible fees and penalties before you sign your mortgage. Can you make prepayments? You may also be charged a fee if you change lenders when your mortgage term matures, so be aware of this before signing.
How much is the mortgage penalty fee?
The mortgage penalty fee depends on what type of mortgage you have. If you have a variable rate mortgage, your penalty fee will be 3 months’ interest. If your mortgage is a fixed rate mortgage your fee will be either 3 months’ interest or the interest rate differential (IRD), whichever is the highest.
This IRD may be calculated over your mortgage term, or may be calculated on the amortization length of your mortgage. Make sure you know how your lender calculates the IRD when considering your mortgage options.
Open mortgages and closed mortgages
There are, of course, no penalties for breaking an open mortgage. Open mortgages have higher rates, but give you the financial flexibility of making prepayments and paying off your mortgage before the end of the mortgage term.
If you break a closed mortgage, you will have to pay a mortgage penalty. Closed mortgages cannot be repaid or refinanced until the mortgage makes maturity. But this lack of flexibility is tempered by the lower rates when compared to an open mortgage. The borrowers who want short term financing will still save money by choosing a closed variable rate mortgage and paying a penalty if they pay out early.
How to avoid a mortgage penalty
You have a better chance of avoiding mortgage penalty fees if you make sure your mortgage allows you to make prepayments. Many lenders permit borrowers to pay up to 20 per cent of their mortgage once per year. This sum is applied to your mortgage principal, and would reduce your interest costs. Always make sure to read your mortgage contract.
If you’re considering refinancing and would be subject to a mortgage penalty, you should take advantage of your prepayment options. Any mortgage penalty will be lower if your principal is reduced.
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