Breaking Your Mortgage (and the Consequences of Doing So)

April 9, 2009  
Filed under Mortgage Options

Sometimes, you might run into a circumstance where you need (or want) to break your mortgage. Breaking your mortgage means that you pay off the outstanding mortgage balance in full prior to the end of your term (for example, paying off your five-year fixed-rate closed mortgage three years into the term). This incurs a pre-payment penalty, which is either the equivalent of three months’ interest payments or the interest rate differential. The lender usually charges the greater of the two.

Three Months’ Interest

The three months’ interest penalty is calculated by multiplying the outstanding balance on your mortgage by the interest rate (per annum) your mortgage is at. That gives you a number, which you then divide by four to get your three months’ interest. This is the penalty you would pay if it was more than the interest rate differential (to be discussed shortly).

For example, say you have a $300,000 mortgage at 5.50%. Multiplying those two together gives us $16,500, which we then divide by four to get the three month interest penalty of $4,125.

Interest Rate Differential

The other method that lenders use to calculate your pre-payment penalty in the event you break your mortgage is the interest rate differential (or IRD). This is basically the amount of lost revenue that the lender would incur if they were to take your mortgage amount and re-lend the money at current market rates. If current rates are lower than the rate on your mortgage, the IRD could be substantial.

In regards to mortgage interest rates, your lender will compare your current interest rate to the rate on a term close to the time remaining in your term. For example, if you are two years into a five-year term, they will compare your mortgage rate to a three year term rate. The idea is to subtract the current mortgage interest rate from the rate you have on your mortgage, which is then multiplied by your outstanding mortgage balance and then the number of years remaining in your term. This gives the lender the amount interest they would be losing if you break your mortgage.

For example, say you have the same $300,000 mortgage at 5.50%, and that it’s a five-year closed term with two years remaining. Also, let’s say that the current interest rate on a two-year closed term is 3.50%. To calculate the IRD, you subtract 3.50% from 5.50% to give a rate of 2.00%. Then this is multiplied by your outstanding balance ($300,000 x 2%) giving you $6,000, which is then multiplied by two (the number of years remaining in your term) to get the penalty – which amounts to $12,000, a fairly significant difference from the three months’ interest.

Currently, mortgage interest rates are at historical lows, so lenders are charging the IRD as opposed to the three months’ interest penalty. If you’re looking to refinance your home to save some money interest-wise, it’s important to ensure that the interest savings outweigh the pre-payment penalty you’re going to incur. A mortgage broker can help you with that, as well as help you refinance if you decide to go ahead with it.

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