To answer this question thoroughly, we first need to make sure we all understand why banks or lenders give out mortgages in the first place. Banks and lenders give out mortgages to make a profit on the interest they charge.
To really maximize their profit, they need to collect this accruing interest over the entire loan term. If you end a mortgage early by paying the balance, you might be subject to a prepayment penalty. These penalties are meant to protect the lender from disrupted income or lower bottom-line than expected.
Since most lenders provide mortgages with a minimum term of 5 years and 60% of borrowers refinance within 3, you can see how many can unwittingly fall into this trap.
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How much are prepayment penalties?
Every bank can set their own terms for their prepayment penalties, however, they are usually constructed in a similar manner. In Canada the traditional method is to take the largest value of the following two options:
- The interest portion of your next 3 monthly payments. For example, if your monthly payments are $1,700 of which $1,100 is the interest portion then you will need to pay $3,300 in penalties.
- The Interest Rate Differential or IRD. Although this one might sound complicated, it’s rather simple once you know how it works. You first establish how long is left on your term. Then you take the lender’s current interest rate for a 2-year term and minus that from your original interest rate. Your penalty will then be the remaining balance of your mortgage times this percentage.
Although the penalty itself might not seem so bad, remember that you are probably making a bunch of other payments at the same time, the total amount when all this is added up could be more than most can swallow:
- If you are selling your home you are most likely paying realtor fees.
- If you are refinancing you are most likely paying broker fees, etc.
- If you are breaking your mortgage you are also paying the balance of the mortgage.
How to avoid prepayment penalties?
The bad news is that once you are locked in a mortgage or loan, there isn’t much you can do to avoid making a prepayment penalty if it’s stipulated in your mortgage terms. The best defence against a prepayment penalty is arm yourself with information when applying for a loan.
Here are some helpful questions to ask yourself?
- Do you want the option to pay down your loan earlier even if it may come at a higher initial interest rate?
- How big is the possibility that you will need to move within the near future?
- Is there any chance of you coming into possession of a lump sum of money that you would like to use to pay off your mortgage?
- How likely are you to need to refinance your loan because of changes in your income or circumstances in the near future?
If you answered very likely to most of these questions, you might want to consider an open mortgage. Open mortgages allow more flexibility, especially when it comes to paying off your mortgage earlier than the term specifies.