How do Mortgage Penalties Work in Canada?

When you originally agree to a mortgage term, you’re probably thinking that you’ll have to serve out the entire term making the same payment with the same interest rate. Whether or not you want to do that can change depending on your interest rate, the economy, and your personal finances. Maybe you’re part way through your term and thinking about switching things up.

If you’re thinking about ending your mortgage term early, you’re definitely not alone. About 70% of Canadians break their mortgage early. 

You might want to break your mortgage contract for several reasons, such as selling your home or refinancing for a better rate. Whatever the reason is, you’ll want to make sure you know how much of a penalty you’ll have to pay for breaking your mortgage contract.

All mortgages come with penalties for breaking early to protect the lenders and investors. It’s important to know the conditions of mortgage penalties and the pros and cons of breaking a mortgage early. It’s also good to consider the mortgage penalty if you’re still shopping for your first mortgage, in case you want to break the mortgage down the road. 

Here are the three most common mortgage penalty calculations:

3 Months’ Interest
The three months' interest penalty is pretty straightforward. Your penalty payment would be the equivalent of what you’d pay in interest over the course of three months. 

Standard Interest Rate Differential
This calculation is based on the amount you’re prepaying, your original interest rate, and your lender’s current interest rate. The amount calculated this way is usually slightly more than the 3 months’ interest calculation.

Discounted Interest Rate Differential
This penalty calculation is frequently used by banks and credit unions. They calculate this penalty by using the posted rate against the discounted rate you got for your original mortgage term. This can often result in the largest mortgage penalty of the three options. Therefore, even though you signed on with the lowest interest rate, it costs you more should you choose to break your mortgage early.

Many people view this as unfair to the homeowner because the lender is comparing an outdated, much lower rate than the client is likely to end up with when they refinance. When considering a new mortgage, this is something to watch out for. 

Now that we’ve outlined the three different ways your penalty could be calculated, you might be curious to do some calculating yourself. Try the RBC Penalty Calculator or Scotiabank Penalty Calculator.

How do you avoid mortgage penalties?

The only way to avoid a penalty is to pay off your mortgage early. In this case, you might even get previous penalties back if you pay it off within a certain amount of time, which will be outlined in your contract. 

That said, you might still be able to reduce the penalty by pre-paying part of your mortgage each year in a lump sum. In this case, the mortgage penalty is calculated based on the remaining balance owed, after the lump sum payment, therefore making the penalty lower. 

Now you know there are many ways a penalty can be calculated, and a few ways you can reduce or eliminate penalties. Whether you’re buying a new home or just planning for the future by reducing your interest rates, you’ll be prepared for the penalties that come along with it. 

Still confused? That’s okay. Book a call with Your Mortgage Guide today and let us help you avoid big mortgage penalties and find the best path forward.