When it comes to mortgages, it is easy to focus on the rates and your current situation, but the reality is that life happens and when it does, rates won’t be the only thing that matter.
At the end of the day, a mortgage is a contract between you (the homeowner) and the bank. As such, there are often penalties involved if the contract is ever broken. This is something that every homeowner agrees to when you sign mortgage paperwork, but it can be easy to forget - until you’re paying the price. These things do happen as approximately 6 out of 10 mortgages in Canada are broken within 3 years. Should your circumstances change, knowing the next steps can help you navigate the process.
Typically, the penalty for breaking a mortgage is calculated in two different ways. Lenders generally use an Interest Rate Differential calculation or the sum of three months interest to determine the penalty. You will typically be assessed the greater of the two penalties, unless your contract states otherwise.
In Canada there is no one-size-fits-all rule for how the IRD is calculated and it can vary greatly from lender to lender. This is due to the various comparison rates that are used. However, typically the IRD is based on the amount remaining on the loan and the difference between the original mortgage interest rate you signed at and the current interest rate a lender can charge today.
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.
In this case, these penalties vary greatly as they are based on the borrower's specific mortgage and the specific rates on the agreement, and in the market today. However, 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.
In some cases, the penalty for breaking your mortgage is simply equivalent to three months of interest. Using the same example as above - balance of $200,000 on your mortgage, an annual interest rate of 6% - then three months interest would be a $3,000 penalty. A variable-rate mortgage is typically accompanied by only the three-month interest 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). You can also pay your penalty up front. Whenever possible, if you can wait out your current mortgage term before making a change to your mortgage, it is the best way to avoid being stuck in the penalty box. If you cannot avoid a penalty, do note that, while only calculators can be great tools for estimates, it is best to contact me directly to discuss your mortgage terms and potential penalty calculations.