A mortgage prepayment penalty is a fee your lender charges when you pay off your mortgage, refinance, or otherwise break your mortgage contract before the end of its term. The amount depends on whether you hold a variable-rate or fixed-rate mortgage, and penalties on fixed-rate products can be significantly larger.
Most closed mortgages in Canada come with prepayment privileges that allow you to put extra money toward your principal each year without triggering a penalty. Lenders typically permit annual lump-sum payments of 10 to 20 percent of the original mortgage balance, and many also allow you to increase your regular payments by a similar percentage. If you stay within those limits, no penalty applies. The penalty kicks in only when you exceed those privileges or break the contract entirely, such as by selling your home, switching lenders, or refinancing mid-term.
For variable-rate mortgages, the calculation is straightforward. The penalty is typically three months of interest on your outstanding balance. On a $400,000 balance at 5 percent, for example, that works out to roughly $5,000.
Fixed-rate mortgages are more expensive to break. Lenders generally charge the greater of three months of interest or the interest rate differential, commonly called the IRD. The IRD measures the gap between your existing contract rate and the rate the lender can currently charge for a term matching the time you have left. That difference is applied to your remaining balance over the months left in your term. When rates have dropped since you locked in, the IRD can produce a penalty of tens of thousands of dollars. Each lender calculates the IRD somewhat differently, and major banks often use their posted rates rather than discounted rates in the formula, which tends to inflate the result.
There is one important federal protection. Under Section 10 of the Interest Act, if your mortgage term is longer than five years and more than five years have elapsed since the mortgage date, the maximum penalty the lender can charge is three months of interest regardless of the IRD. This applies to individual borrowers, not corporations.
Before breaking a mortgage, request a written penalty quote from your lender. You can also reduce a future penalty by using your prepayment privileges each year, which lowers the outstanding balance the penalty is calculated on. If you are selling one property and buying another, porting your mortgage to the new home can sometimes allow you to avoid the penalty altogether.
