If you’re thinking about refinancing your mortgage, breaking it early or prepaying a lump sum to pay it down faster, there’s a few important details you should keep in mind. When it comes to getting a mortgage, many homeowners are preoccupied with finding the best rates to save them the most money. However, people often overlook the importance of the prepayment privileges and penalties that come with the mortgage and lender you choose. Understanding these details are fundamental to avoid unfavourable penalties should you decide to make any changes to your mortgage before the term ends.
What are prepayment penalties?
Prepayment penalties are used to cover the cost that a lender might incur should a homeowner make a payment that exceeds the prepayment privileges allowed for their mortgage (i.e. to break their mortgage early). It’s a penalty that could cost you tens of thousands of dollars depending on the conditions that your lender has. Given that every lender is different, it’s very important to know these details when looking for a mortgage. So, while you may get savings up front with some lenders, you could also wind up with thousands of dollars in penalties in the long run.
This is why it’s so important to get clear on the penalties associated with your mortgage term to avoid any surprises. If your goal is to pay off your mortgage quicker, there are prepayment privileges available that are available monthly and annually (i.e., a 20% monthly lump sum). The best thing to do is look into what your mortgage privileges are and understand how much you’re allowed to prepay on top of your regular mortgage payments, without penalty.
When do these charges apply?
Prepayment privileges and penalties vary between lenders, so it’s a good idea to read over the terms and conditions of your mortgage contract to understand all of the details before you make any decisions. Our team at Homewise always ensure that we provide unbiased advice to our clients about these clauses, so contacting a mortgage professional is also very helpful. Here are a few scenarios where a homeowner might incur prepayment penalties:
If you sell your home and choose to pay out the mortgage before its maturity date
If you renew your mortgage before its maturity date
If you pay an amount greater than your allowable prepayment privilege
If you refinance your mortgage
If you transfer your mortgage to another lender
How are prepayment penalties calculated?
There are two different ways to calculate prepayment penalties on a mortgage. If you have a fixed-rate closed mortgage, your lender will take the greater of the amount equal to three months’ interest on the amount you’ve prepaid or the interest rate differential (IRD). The IRD is the difference between the interest rate on your current mortgage and today’s interest rate for a term that is the same duration of what’s left on your mortgage. If you ever go on a large lenders’ site and notice their rates look much higher than what’s in the market, that’s because they’re using that same high rate to calculate your IRD – which is why some prepayment penalties can be upwards of $30,000+.
If you have a variable-rate closed mortgage, your penalty will only be calculated based on three months' interest. So variable holders don’t have to worry about potentially large IRD penalties.
How can you avoid prepayment penalties?
Some lenders and mortgage types can have larger penalties, such as big banks and low-rate no frills lenders, who can charge up to tens of thousands of dollars. So, if you see yourself as someone who is more likely to make additional payments to pay down your mortgage or if you may have to break your mortgage early, shopping around will allow you to find a lender with lower prepayment penalties.To find out exactly what your prepayment privileges and penalties are, it’s important that you ask your lender key questions, including the following:
Do I have any prepayment privileges?
What is the amount that can be prepaid without incurring any penalties?
Are there any fees for making early prepayments?
How often can prepayments be made?
When can prepayments be made?
What is the maximum prepayment amount?
How does breaking my mortgage work if I have to end my term early?
By getting clear on all of these details from the start, you can make thoughtful decisions to ensure that there are no surprises and you can avoid substantial costs in the future.
At Homewise, we work with over 30 banks and lenders to help buyers find the best mortgage, while providing an unbiased Advisor to help at each step. If you’re interested in breaking your mortgage early, refinancing or looking to pay down your mortgage as quickly as possible, we can help you shop around and find the best mortgage that fits your unique circumstances and homeownership goals. Apply online today in just 5 minutes and one of our Mortgage Advisors will get in touch and guide you every step of the way.