The penalty clause is perhaps the most important feature, or term/condition, of a mortgage. It is often overlooked and misunderstood. Unfortunately many borrowers become very familiar with how it works only once they find themselves on the wrong end of an unexpected $10,000 bill that needs to be paid.

This fee is only ever charged if you repay the entire balance of your mortgage all in one shot. Basically you're cancelling the contract and walking away, and this could be for a variety of reasons, including refinancing the mortgage, selling the property and using a different lender/lower rate etc., coming into enough money to pay off the mortgage, and so on. There are many ways to avoid paying the penalty, including porting the mortgage or refinancing right at renewal time.

If you do end up paying a penalty, how much you pay is dependent on the lender, the mortgage term, your interest rate, the discount you received on your rate, current market rates, and the mortgage product.

Variable rates

If you have a variable mortgage rate, you will virtually always pay three months' interest.

Restricted rate mortgage products (ultra-discounted rates)

For those with an ultra-discounted mortgage rate (a restricted product) the penalty clause is often one of the trade-offs for the lower rate. The penalty clause may be something like 2.5% to 3% of the outstanding balance (a $330,000 mortgage would produce a nearly $10,000 penalty). This alternate calculation is in addition to the 3 months' interest calculation, and the interest rate differential calculation, both outlined below. The amount you pay is determined by computing the penalty amount using all three methods and choosing the largest number.

Restricted rate products frequently have something called a bone fide sale clause which means the only way to get out of the mortgage is by selling the property to an unrelated and un-associated buyer. In that case, the penalty clause as listed in the mortgage agreement will apply, but only if the property is sold to a non- arms-length buyer, i.e. someone who is unrelated to and un-associated with you.

Standard mortgage products

Typically, in a standard mortgage (not a restricted rate), the penalty that applies is the greater of 3 months' interest, or the interest rate differential.

3 months' interest

This is calculated by taking the amount owing on the mortgage, and multiplying it by the amount remaining on the mortgage. Take the result, and divide it by 12. This gives you the monthly amount. Multiply that number by 3 to get 3 months' interest. For example, suppose the mortgage amount outstanding is $300,000, and the interest rate is 3%.

$300,000 x 3.5% = $10,500 (1 year's interest)
$10,500 ÷ 12 months = $875 (one month's interest)
$875 x 3 months = $2,625

The 3 months' interest penalty would be $2,625.

Interest rate differential (IRD)

IRD refers to the calculation that looks at your mortgage interest rate in comparison to the interest rate your lender currently charges, for a term that is close to the amount of term you have left. To calculate the IRD, follow these steps:

  1. Find out the amount that is still owing on your mortgage, and the original rate you paid. If you received a discount on your mortgage rate, this will be specified in your original mortgage agreement, and will be included in this calculation. Add the discount you received to your current rate.
  2. Determine how much time is left in your mortgage term. Look up the current mortgage rate your lender offers to new borrowers that sign up for the same term as you have left remaining. For example, if you have three years left on your mortgage term, find out what rate your lender would offer for new buyers signing a three-year term.
  3. Subtract the lender's current rate for an equivalent term from your rate, to determine the difference in rates, or the interest rate differential.
  4. Take the interest rate differential from step 3 and multiply it by the amount owing on your mortgage. Divide that number by 12
  5. Multiply the amount in step 5 by the number of months remaining in your mortgage.

IRD with a rate discount received

Suppose you have a mortgage of $300,000 at a rate of 3.5%, a discount of 1.75% was received at the beginning of the contract, there are 24 months left in the term, and the current 2 year rate with the lender is 2.75%.

  1. There is $300,000 remaining on the mortgage, and the rate is 3.5%. A discount of 1.75% was received at the start of the mortgage term. The total rate for the calculation is 5.25%.
  2. There are 24 months left on the term, and the current rate charged by the lender for a 2 year term is 2.75%.
  3. The current rate (plus discount) of 5.25% minus the lender's current 2 year rate of 2.75% equals 2.5%. The interest rate differential is 2.5%.
  4. The interest rate differential of 2.5% x the $300,000 remaining on the mortgage is $7,500 per year. $7,500 ÷ 12 months = $625/month
  5. With 24 months remaining and a penalty of $625/month, the total interest rate differential penalty amount is 24 x $625 = $15,000

The interest rate differential penalty amount is $15,000 in this example.

IRD with no rate discount received

Many lenders do not "discount" their rates up front and instead offer you best rates without an arbitrary discount. The same calculation without any rate discount up front would look like this:

  1. There is $300,000 remaining on the mortgage, and the rate is 3.5%. No rate discount was received. The total rate for the calculation is 3.5%.
  2. There are 24 months left on the term, and the current rate charged by the lender for a 2 year term is 2.75%.
  3. The current rate of 3.5% minus the lender's current 2 year rate of 2.75% equals 2.5%. The interest rate differential is 0.75%.
  4. The interest rate differential of 0.75% x the $300,000 remaining on the mortgage is $2,250 per year. $7,500 ÷ 12 months = $187.50
  5. With 24 months remaining and a penalty of $187.50/month, the total interest rate differential penalty amount is 24 x $187.50= $4,500

The interest rate differential penalty amount is $4,500 in this example.

Calendar math is where it gets tricky

Things can get tricky when language in the mortgage contract is not clear. For example, if you have 23 months left on your term, should the 2 year rate be used, or since a 2 year term isn't possible (23 months is less than 2 years after all) does the 1 year rate get used? Sometimes these scenarios are spelled out in detail and it will be clear as to what rate should apply, and other times it is not clear at all. The difference can have a significant impact on your payout penalty, in the thousands of dollars.

Suppose your lender's policy is to use a term that is closest to how many months you have left. If you have 31 months remaining in your term, you are closer to a 3 year term than a 2 year term. But once you get to 30 months less 1 day, you will be closer to a 2 year term. If the 2 year rate is lower than the 3 year rate, your penalty amount will be higher.

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