Breaking a mortgage contract is more common than you might think, whether due to an unexpected move, refinancing for better terms, or a change in personal circumstances. However, many borrowers overlook the significant penalties that can arise when breaking a mortgage. Understanding these penalties before signing a mortgage contract can save you thousands of dollars.
What Are Mortgage Penalties?
Mortgage penalties are fees charged by your lender when you break your mortgage contract before its term ends. They act as compensation for the lender’s loss of anticipated interest payments. The type and size of the penalty can vary widely depending on the type of mortgage you choose—fixed or variable rate—and the terms specified in your agreement.
Fixed vs. Variable Rate Mortgages: A Key Difference
The calculation of mortgage penalties differs greatly between fixed and variable rate mortgages:
- Fixed-Rate Mortgages: The penalty is usually the greater of three months’ interest or the Interest Rate Differential (IRD). The IRD is based on the difference between your current mortgage rate and the rate your lender can charge for a loan of the same size and remaining term.
- Variable-Rate Mortgages: The penalty is typically simpler and limited to three months’ interest, which often makes variable-rate mortgages more flexible for borrowers who may need to break their contract.
Why Do People Break Their Mortgages?
Borrowers may break their mortgages for a variety of reasons, including:
- Relocating due to work or personal reasons.
- Refinancing to take advantage of lower interest rates.
- Accessing home equity for large expenses like renovations or debt consolidation.
- Divorce or separation.
Whatever the reason, it’s essential to factor in the cost of penalties before making a decision.
Strategies to Minimize Mortgage Penalties
- Understand Prepayment Privileges: Many mortgages allow you to make lump sum payments or increase your regular payments without penalties. These privileges can help reduce the principal faster, potentially lowering your penalty if you later break the mortgage.
- Choose a Portable Mortgage: If you anticipate moving, consider a portable mortgage, which allows you to transfer your existing terms and rate to a new property, avoiding penalties.
- Opt for a Variable Rate Mortgage: If flexibility is important to you, a variable rate mortgage may be the better choice due to its lower penalty structure.
- Work with a Mortgage Agent: A knowledgeable mortgage agent can help you understand the fine print and identify lenders with more favorable penalty terms.
Real-Life Example of Mortgage Penalties
Let’s say you have a $400,000 fixed-rate mortgage at 3% interest with three years remaining on a five-year term. Your lender’s posted rate for a two-year term is now 2%. Using the IRD calculation, your penalty could be thousands of dollars, depending on the remaining balance and term.
If you had a variable-rate mortgage, however, your penalty would likely be much lower—around three months’ interest, or about $3,000 on a similar balance.
Why This Matters
Failing to understand mortgage penalties can lead to unexpected financial stress. For example, if you plan to sell your home within a few years or foresee needing to refinance, knowing the penalty structure in advance allows you to make an informed decision.
Let’s Make Sure You’re Informed
Avoiding hefty penalties starts with understanding your mortgage contract. By working with a mortgage agent, you can review your options and ensure your mortgage aligns with your financial goals and potential future changes. I’m here to help you navigate these details and find the right solution.
Read the full list of the top 10 mistakes to avoid when getting a mortgage here: Top 10 Mortgage Mistakes
Have Questions? Let’s Talk.
If you’re unsure about your mortgage penalties or need help navigating your options, I’m here to assist. You can call me directly at (613) 318-6315 or schedule a free 15-minute mortgage advice session.
Let’s find the best solution for your unique situation!
-Phil