Understanding Mortgage Pre-payment Penalties: Why They Rise When Rates Fall — And Why Some Borrowers Still Break Their Mortgage Early
When it comes to mortgages in Canada, one of the most confusing and frustrating surprises homeowners face is the dreaded pre-payment penalty. It's something we often don't think about until we're considering breaking a mortgage — whether to refinance a property, sell, or switch lenders.
At MMG Mortgages we believe in empowering and educating our clients – and doing all we can to help you make informed decisions. So, let’s unpack what prepayment penalties are, why they tend to increase when interest rates drop, and why breaking your mortgage might still make sense in some cases.
What Is a Mortgage Prepayment Penalty?
A pre-payment penalty is a fee charged by your lender if you pay off your mortgage — or more than your allotted pre-payment privileges — before the term ends. It’s their way of recovering some of the interest income they expected to earn over the full term of your loan.
There are two main ways lenders calculate this penalty:
Three Months’ Interest – This is exactly what it sounds like: you pay three months’ worth of interest on your remaining mortgage balance.
Interest Rate Differential (IRD) – This is the more complex (and often more costly) method used by lenders for fixed-rate mortgages. For simplicity, it’s calculated based on the difference between your current rate and the rate the lender can charge someone today for a loan of the remaining term.
Why Do Penalties Go Up When Rates Go Down?
It feels counterintuitive, right? If rates are lower, shouldn’t it be easier to switch? Here’s the reality:
With IRD penalties, the lower the current interest rates compared to your original rate, the bigger the gap — and the larger the penalty.
Let’s say you locked in a 5-year fixed rate at 5% two years ago, and today’s 3-year rates are around 3%. If you break your mortgage now, the lender is losing out on 2% worth of interest for the next three years — and they’ll charge you for that.
That’s why we see a surge in hefty pre-payment penalties when rates drop — and many borrowers are left wondering whether it’s worth it to pay up.
Why Would Anyone Break Their Mortgage Early?
Despite the penalties, there are plenty of good reasons to break your mortgage early:
1. To Lock In a Much Lower Rate:
If interest rates have dropped significantly, even after paying a penalty, the long-term savings on a lower interest rate can outweigh the upfront cost.
2. Debt Consolidation:
Refinancing to roll high-interest debt (like credit cards or personal loans) into a lower-rate mortgage can lead to big monthly savings and lower monthly debt payments.
3. Life Changes:
Job relocations, divorces, or changes in family needs can lead to selling the home or needing a new mortgage structure.
4. Tapping Into Equity:
Homeowners might want to access the equity in their home for renovations, investments, or other financial goals.
What’s the Smart Move?
Before making any decisions, we highly recommend getting a penalty quote from your lender — and then speaking to your MMG Mortgages Professional who can help you do the math. Sometimes, the penalty is worth paying. Other times, we can explore penalty-free options like blending and extending or waiting until closer to your maturity date.
Pre-payment penalties aren’t fun — but they’re not always a dealbreaker either. Whether you’re eyeing a better rate, restructuring your finances, or navigating a life change, breaking your mortgage might still be the right move.
We’re here to help you look at the big picture and guide you toward the best decision for your future.
Thinking about breaking your mortgage? Let’s run the numbers together. Reach out today for a free consultation.