Preparing To Break Your Mortgage? Here’s What You Need To Know!

In a perfect world, you would never need to break your mortgage before the end of its term, however, that is rarely the reality. If you, like many homeowners, are planning on breaking your mortgage in the near future, it is important to fully inform yourself of the potential fees and associated consequences before beginning the process. Much like a skilled architect meticulously plans the foundation before constructing a masterpiece, preparing to break your mortgage demands a well-thought-out blueprint. In this guide, we will cover everything from the types of prepayment penalties to the differences between open and closed mortgages, to arm you with the information you need to succeed.

What Does it Mean to Break a Mortgage?

In Canada, "breaking a mortgage" most often refers to terminating an existing mortgage contract before the agreed-upon amortization period has passed. When you decide to break your mortgage, you are typically deciding to pay off your mortgage earlier than you initially agreed upon with your lender. Homeowners may choose to break their mortgage for a number of reasons, be it refinancing to take advantage of lower interest rates, selling the property, or paying off the mortgage through lump sum payments.

However, breaking a mortgage before the predetermined term completion often comes with penalties and fees, which can be substantial depending on the terms outlined in the mortgage agreement. Lenders use penalties to compensate for the interest income they lose when a borrower terminates their mortgage early.

The penalties for breaking a mortgage in Canada can vary widely depending on factors like the type of mortgage (fixed-rate or variable-rate), the outstanding balance, the remaining term, and the specific terms outlined in the mortgage agreement. If you’re considering breaking your mortgage, It's essential that you carefully review your mortgage contract, understand the penalties involved, and assess whether the potential savings or benefits from breaking the mortgage outweigh the associated costs. Clover Mortgage offers free consultations to help direct you and can provide valuable guidance as you make an informed decision.

Reasons To Break Your Mortgage Contract

There are several reasons why a homeowner might want to break away from their mortgage contract, including:

• Selling your home
• Paying off the mortgage early
• Mortgage refinance to lock in a better rate
• Renegotiate a new agreement with better terms
• Removing someone from the title of the property and from the mortgage

Whatever your reason may be for getting out of your mortgage early, it is possible that you may be charged a prepayment penalty. A good mortgage broker can help you become familiar with your mortgage contract and understand more about the process and any potential costs that you would encounter.

If your main goal for breaking your mortgage is to put yourself into a better financial situation, you should always factor in the costs before making any final decisions. Depending on your mortgage agreement and your lender's requirements, you could stand to benefit a great deal by breaking your current mortgage early and refinancing the entire amount, or you might end up realizing that the process will end up costing you more than you would make in the long run.

Open vs. Closed Mortgages

If you are thinking about breaking your mortgage, the first step is to understand the difference between an open mortgage and a closed mortgage. The second step is to identify which one you have.

Closed mortgages have very specific terms regarding interest rates, payment schedules, and amortization period lengths. These terms are locked in and cannot be changed without incurring penalties. One of the most significant limitations is regarding prepayment options. Typically, there's a maximum amount you can prepay each year without facing penalties. Any additional payments beyond this limit could cause you to incur huge prepayment penalties. On the upside, closed mortgages often have lower interest rates compared to open mortgages since they offer less flexibility. They are best suited to individuals seeking stability and predictability in their mortgage payments and who don't anticipate major changes in their financial situation during the mortgage term.

Open mortgages offer more flexibility than their counterparts. They allow you to repay your mortgage, either partially or in full, at any time without incurring prepayment penalties. With open mortgages, there are no limitations on prepayment amounts. Borrowers can often pay off the entire mortgage or make additional payments without facing penalties. As a result, open mortgages typically have higher interest rates compared to closed mortgages due to the added flexibility they offer. Thus, open mortgages are most suitable for those expecting significant financial changes and/or those planning to sell their home in the near future. They are also beneficial for those who prefer the flexibility to make lump-sum payments towards their mortgage without penalties.

Cost Of Breaking Your Mortgage

Breaking your mortgage early could result in some costs that you have to cover as a homeowner, including but not limited to:

• Prepayment penalties
• Administration fee
• Appraisal fee
• Re-investment fees (if you are trying to purchase a new home)

As far as pre-payment penalties are concerned, there are typically two primary methods that lenders use to calculate these fees: three months’ interest penalty, and interest rate differential (IRD) penalty. Variable rate mortgages most often incur the three months’ interest penalty, while lenders of fixed rate mortgages will often analyze the fees determined by both the three months’ interest method and the IRD penalty, and charge you the higher of the two.

Three Months’ Interest Penalty

Some lenders may charge a penalty equivalent to three months' worth of interest payments on the remaining mortgage balance. This method is simpler but may not accurately reflect the actual interest loss incurred by the lender.

Here is a sample calculation of what you might expect to pay on a variable rate mortgage if you are being penalized for 3 months of interest:

Prepayment Penalty Amount = Current Interest Rate x Mortgage Balance x 3 Months

For example, if you have a mortgage balance of $400,000 and your current monthly mortgage payment is $2,500 a month of which $500 goes towards paying interest and the remainder towards paying down the principal, then here is how you can calculate a rough estimate for your mortgage prepayment penalty on many variable rate mortgages using the figures in this example:

Prepayment Penalty Amount = $500 x 3

Prepayment Penalty Amount = $1,500

Interest Rate Differential Penalty

The Interest Rate Differential (IRD) is a formula used by lenders to calculate the penalty charged to a borrower for breaking a closed mortgage contract before the term ends. It is the difference between the interest rate on the existing mortgage and the current interest rate for a mortgage term that matches the remaining term of the original mortgage.

When a borrower breaks a closed mortgage early, the lender loses the interest income it would have received had the borrower continued with the agreed-upon term. The IRD is designed to compensate the lender for this lost income.

The formula for calculating the IRD penalty can vary between lenders but generally involves comparing the interest rate on the existing mortgage with the interest rate the lender would charge for a similar mortgage with a term that matches the remaining term of the original mortgage. The difference in these rates, along with the outstanding principal balance and remaining term, determines the penalty amount.

Here's a simplified sample calculation for an IRD penalty:

Let's assume:

Original mortgage amount: $300,000

Remaining term: 3 years

Original interest rate: 4.5%

Current interest rate for a 3-year term: 3.5%

Using the IRD formula:

Determine the Interest Rate Differential:

Current Rate for a Similar Term - Original Mortgage Rate = IRD

3.5% - 4.5% = -1%

Calculate the Penalty:

Penalty = IRD * Remaining Principal * Remaining Term

Penalty = -1% * $300,000 * 3 years = -$9,000

Breaking Your Mortgage Early

Depending on the numbers used in your calculations and mainly by the months left on your mortgage, the amount you would owe in penalties might be in the thousands of dollars. If you are looking to resign with your current lender, they may be willing to reduce your penalties in order to make you stay. However, it is always beneficial to shop around with other lenders since customers that are refinancing with the same lender are typically given less competitive rates than new customers. Your best option is to always speak with an experienced mortgage broker who can provide you with unbiased information and sound advice on the most suitable mortgage solutions for your financial future.

Avoiding A Hefty Prepayment Penalty

If you are contemplating breaking your mortgage but feel yourself getting swayed by the thought of having to potentially pay thousands in penalties, these are some things you can look into.

1. Know Your Contract Inside And Out: Read your mortgage contact closely and make sure you are familiar with all of the options and terms included. This can potentially give you a legup if you end up wanting to break your mortgage contract early. Certain contracts will give you the options to pay down more of your mortgage each year with a yearly lump sum payment and/or increasing your monthly payment amounts without having to pay a penalty. You can take advantage of this annual lump sum or increased monthly payment clause in your contract to your advantage when you break your mortgage early in order to have to face a lower prepayment penalty.
2. Blend And Extend Mortgage: If you are interested in extending your mortgage but want to avoid paying a prepayment penalty, you can opt for this option. It allows you to mix your current interest rate with the current market rate being offered and create a new rate somewhere in between. You would need to speak with your lender or a mortgage broker to learn more about this option and whether it would be a financially beneficial solution for you.
3. Port Your Mortgage: If you are breaking your mortgage in order to sell your home and buy a new one, you can speak with your lender about the potential option of porting your mortgage to the new property. This option allows you to transport your current mortgage to your new property and might be able to help save you unnecessary prepayment costs. Porting your mortgage can save you money and time in the long run, but not every lender is willing to allow it. Talk to your lender or mortgage broker about whether porting your mortgage would be a viable option for you.
4. Allow Your Home Buyers To Assume Your Mortgage: If you are breaking your mortgage in order to sell your home, your buyers could potentially take over your mortgage so you don’t technically have to break the contract. Although it seems like an ideal option for borrowers who are looking to sell with no strings attached, not all lenders are open to the idea and could make it a tedious process to undergo. If your mortgage lender is open to this, the new borrowers (the buyers) will need to be able to qualify based on the lender's guidelines.

Conclusion

All in all, when breaking your mortgage contract the most important thing you can do is educate yourself on the potential fees and penalties that come with your mortgage so that you are prepared and ready to make the best financial decision possible. Besides your own research, it is always recommended to speak with a knowledgeable mortgage broker who can help you better understand the rules and regulations around breaking your specific mortgage contract.

The hardworking team of mortgage brokers at Clover Mortgage are experienced with helping our customers breaking mortgage contracts while ensuring the borrower always comes out on top. We will work alongside you and your lender to make sure you are making the right choice for your financial future.

Call or text us at 416-674-6222 or email us directly at info@clovermortgage.ca to speak with one of our experienced mortgage brokers today.