Why mortgage penalties matter

Written by Sean Cooper

Friday, April 27th, 2018

When you're house hunting, mortgage penalties are probably the last thing on your mind — you're likely more concerned with your mortgage rate than the mortgage penalty. While the interest rate is important, it's also important to pay close attention to mortgage penalties. Although you may not have any intention of breaking your mortgage, it's better to plan ahead since mortgage penalties can end up being quite costly.

Why break your mortgage?

You probably aren't planning to break your mortgage when signing on the dotted line, but life has a way of throwing us curveballs. A mortgage is a long-term commitment. The typical mortgage term is five years. And unless you have a crystal ball, it's hard to plan for unforeseen circumstances.

Common reasons to break your mortgage include: financial hardship, divorce, relocating and taking advantage of lower mortgage rates. For example, what if you lose your job and then find a new one at lower pay? In this situation, you might not be able to comfortably afford your existing mortgage payments, so you may decide to sell your home before your mortgage term is up.

Five-year fixed rate mortgages are most popular with Canadians. Many Canadians are willing to pay a premium to know that their mortgage rate won't change for the length of their term. Even though homebuyers flock to five-year fixed rate mortgages, the average five-year mortgage only lasts three or four years. Many homebuyers don't realize how costly mortgage penalties can be. You can end up paying a four or five digit penalty for breaking your mortgage early.

How do mortgage penalties work?

Mortgage penalties are different depending on whether you have a variable or fixed rate mortgage.

With a variable rate mortgage, your mortgage penalty is often simply three months interest. With a fixed rate mortgage, your penalty is usually the greater of three months interest and something called the Interest Rate Differential (or IRD for short). You could end up paying three months interest, but oftentimes you end up paying a lot more. The IRD is a formula that takes into account the money lenders potentially lose when you break your mortgage. It also considers the interest rate that would apply if they were to lend out the funds today.

While some lenders use the discount rate (the lower rate your lender offered you when you signed up) when determining the IRD, others use the posted rate (the mortgage rates lenders advertise to borrowers).

Be sure to ask your lender which rate is used, as the posted rate can prove quite costly. Some lenders even have steeper penalties like six months interest or three percent of principal.

Before signing up for a mortgage, find out if it's portable. With a portable mortgage, if you decide to move during the term of your mortgage, you can “blend and extend" your mortgage, combining your current mortgage rate with the mortgage rate available today for a new term, while avoiding the costly penalty.

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