What Are the Penalties for Breaking a Mortgage Contract?

(Nine-minute read time)
Updated September 2024

With the Bank of Canada recently reducing interest rates and signaling potential future cuts, now might be the perfect time to consider breaking your mortgage to lock in a lower rate. However, before making any decisions, it's important to understand how mortgage penalties work and whether the potential savings outweigh the costs. By navigating these penalties effectively, you can refinance or break your mortgage in a cost-effective way, potentially saving you thousands.

In this article, we'll guide you through the complexities of mortgage penalties in Ontario. We'll cover why penalties may vary, the differences between fixed and variable rate penalties, how to calculate them, and when breaking your mortgage might be worth it. Plus check out our FAQ at the end of this article.

What Does It Mean to Break a Mortgage Contract?

Breaking a mortgage contract in Ontario means ending your mortgage agreement before the end of its term. This could be due to refinancing, selling your home, or switching lenders. When you break your mortgage contract, you may incur penalty fees. Your penalty fees can vary depending on factors such as how long you’ve had your mortgage term and if your mortgage rate is fixed or variable. However, depending on your situation, the potential benefits may outweigh the penalties.

It’s important to be familiar with your mortgage contract. For some mortgages, You can’t break the contract unless you are selling your home, also known as a Bona Fide Sales Clause. Additionally, different mortgage products can have different penalty calculations, such as the No Frills Mortgage. No Frills Mortgage typically offers a lower interest rate but comes with stricter terms and higher penalties for breaking the mortgage. This can make it more costly to exit the mortgage early compared to a standard mortgage.

Alternatively, if you have a variable-rate mortgage, you may want to consider locking in your rate instead of breaking the contract. Locking in allows you to switch to a fixed rate without incurring penalties. This can be strategically beneficial when interest rates are expected to increase, protecting you from future hikes. Additionally, locking in provides predictable monthly payments, which can help with budgeting and long-term financial planning, all without the added costs of breaking your mortgage.

Reasons Why Your Mortgage Penalties May Vary

1. Length of Time in Mortgage Term: Your penalty fees can vary depending on how long you've had your mortgage term. The earlier you break your mortgage in the term, the higher the penalty is likely to be.

2. Type of Mortgage Rate: Whether your mortgage rate is fixed or variable significantly affects the penalty calculation. Fixed-rate mortgages often have higher penalties than variable-rate mortgages.

3. Remaining Balance: The amount of your remaining mortgage balance influences the penalty. A higher remaining balance will result in a higher penalty.

4. Current Interest Rates: The difference between your mortgage rate and current interest rates can affect the penalty, especially for fixed-rate mortgages.

5. Lender's Calculation Method: Different lenders may have different methods for calculating penalties, particularly the Interest Rate Differential (IRD). It’s essential to understand your lender’s specific calculation method.

6. Mortgage Type and Conditions: The specific conditions of your mortgage, such as whether it’s open or closed, can impact the penalty fees. Open mortgages typically have lower or no penalties compared to closed mortgages.

Reasons Why You’d Break Your Mortgage

1. Take Another Mortgage with the Same Lender: To secure a lower interest rate.

2. Access to More Money: To tap into the equity built up in the property.

3. Increase Amortization: To lower monthly payments by extending the amortization period.

4. Mortgage with a Different Lender: To obtain better terms or rates.

5. You’re Selling: The property is being sold.

6. Renovations or Home Improvements: To obtain funds for substantial upgrades or repairs.

7. Investment Opportunities: Using home equity to invest in other real estate or financial opportunities.

8. Switch from Variable to Fixed Rate (or vice versa): To better match financial goals or market conditions.

9. Change in Financial Situation: Improved credit score or increased income qualifying for better mortgage terms.

Fixed vs. Variable Rate Mortgage Penalties

• Fixed-Rate Mortgages: The penalty for breaking a fixed-rate mortgage is usually higher when interest rates are lower than your existing rate, and is typically calculated with the interest rate differential (IRD) (see below for more information on IRD). For example, if you locked in a fixed rate of 5%, and current rates are 3%, the penalty would be higher. However, if current rates rise above your fixed rate, the penalty would typically be lower.

• Variable-Rate Mortgages: The penalty for breaking a variable-rate mortgage is generally simpler and often less costly, typically calculated as three months’ interest. The effect on rates and penalties for variable-rate mortgages is the opposite of fixed-rate mortgages. For instance, if variable rates go down, the penalty decreases. If variable rates go up, the penalty increases.

Over time, as the term length lowers, the differences between the penalty amounts of fixed and variable-rate mortgages decrease until they eventually equal the same amount. To learn more about fixed vs. variable rates, read our article: When Do Mortgage Rates Go Up?

How to Calculate Mortgage Penalties

Each lender has its own method for calculating penalties. Typically, banks and traditional lenders use either a three-month interest charge or an interest rate differential (IRD), whichever is higher. Here is a breakdown of both methods of calculating penalties:

• Three Months’ Interest: This is the simpler calculation, often used for variable-rate mortgages. It’s the amount of interest you would pay over three months. For example, if your monthly interest is $500, the penalty is $1,500 ($500 x 3).

  • Alternatively, you can get a general estimation by multiplying 1-2% of your overall mortgage (this varies depending on your rate). For instance, a mortgage of $300,000 remaining could have a penalty between $3,000 to $6,000.

• Interest Rate Differential (IRD): This calculation is often used for fixed-rate mortgages. It’s the difference between your current mortgage rate and the rate for a new mortgage with a similar remaining term length that you currently have, multiplied by the remaining balance and time left. For instance, if you owe $200,000 with 2 years left and you find the current rate for a new mortgage with a term of 2 years. If the rate difference is 1%, the penalty would be $4,000 (1% of $200,000 for 2 years).

As the term length decreases over time, the IRD amount will also decrease. Selling your house in a year will have a lower penalty than if you sold your house today. To get the best estimate on your penalty, visit your lender's website to use their mortgage penalty calculator. If you cannot locate their calculator online, contact them directly.

How Big Banks Calculate Mortgage Penalties

The Big Five banks (BMO, Scotiabank, CIBC, RBC, and TD) often use a more complex method to calculate mortgage penalties compared to other lenders (credit unions, monoline, and other banks). They frequently employ discount rate calculations that favor the bank, resulting in significantly higher penalties for borrowers. In contrast, other lenders outside the Big Five banks tend to have simpler and often lower penalty structures.

This doesn’t mean that working with big banks is a bad thing. Just consider this difference when evaluating your mortgage options with your mortgage broker.

When is Breaking a Mortgage Worth It?

When deciding whether to break your mortgage, it's essential to weigh the potential benefits against the costs. Here are some reasons breaking a mortgage might be worth it:

• Potential Savings: If the new mortgage rate is substantially lower than your current rate, the savings over time may outweigh the penalty.

• Financial Needs: If you need to access your home equity for major expenses like renovations, debt consolidation, or investment opportunities, the benefits might justify the cost.

• Improved Conditions: Switching to a mortgage with more favorable conditions, such as extending the amortization period to lower monthly payments, might be advantageous, depending on your situation, even with a penalty.

• Better Alignment with Your Personal Circumstances: Significant life changes such as marriage, divorce, having children, or job relocation might require a different mortgage structure to better suit your new financial situation.

Fixed vs. Variable Rates and Breaking Your Mortgage

If you're buying or renewing now, your decision between fixed and variable depends on how much risk you're willing to take and where you think rates are heading. If you value stability and rates are expected to rise, a fixed-rate mortgage is a safer bet. If you’re open to flexibility and expect rates to drop, a variable-rate mortgage might offer more short-term savings.

For those considering breaking their mortgage, weigh the penalties against the savings from securing a lower rate. A mortgage broker can help you crunch the numbers to decide if breaking your mortgage or renewing with a fixed or variable strategy is the right move for you.

To learn more about the additional mortgage costs at the end of a mortgage, read our article: How Much Does a Mortgage Cost in Ontario?

The Importance of Cost-Benefit Analysis

Before making any changes that could incur penalties, perform a cost-benefit analysis. Assess whether the potential savings or benefits of refinancing, modifying, or selling your property outweigh the penalty fees. Factors to consider include lower interest rates, reduced monthly payments, or enhanced financial flexibility. Consulting with a mortgage broker can provide valuable insights and help you make an informed decision.

Decide if Breaking Your Mortgage is Worth it in 3 Steps:

Alternatives to Breaking Your Mortgage

If breaking your mortgage isn't the best option for you right now, consider these alternatives that can help you manage your finances and avoid hefty penalties:

• Porting Your Mortgage: Porting your mortgage allows you to transfer the terms of your existing mortgage, including the principal amount, interest rate, remaining term, and amortization period, to your new home. This process could help you avoid paying a prepayment penalty.

• Assumable Mortgage: If you have an assumable mortgage, you have the option to transfer it to the buyer of your property when you sell it. If the mortgage has favorable interest rates and terms, the buyer might want to assume it, which can lower their overall costs and help you avoid paying a prepayment charge. The new borrower will need approval from the lender, but this can be a smooth way to continue the mortgage without breaking it.

• Renewing Your Mortgage Early: Depending on your mortgage contract, you might have the option to renew your mortgage early without incurring a prepayment penalty. This can be beneficial if interest rates have dropped or if you want to change the terms of your mortgage.

• Taking Equity Out of Your Home: As you pay your mortgage principal or your property value increases, you build equity in your home. You can leverage this equity by opening a Home Equity Line of Credit (HELOC), which may offer a lower interest rate compared to other loan types.

• Locking in from a Variable Rate: If you have a variable-rate mortgage, you can avoid breaking the mortgage by locking in your rate. This allows you to convert your variable rate to a fixed rate without penalties. It’s a great option if you want to protect yourself from potential rate increases while avoiding the costs of breaking your mortgage.

Conclusion

Breaking your mortgage involves careful consideration of penalties versus benefits. Understanding how these penalties work and taking advantage of the best time to break your mortgage could save you thousands. Always consult your financial advisor to make an informed decision that aligns with your financial goals.

Start today so you can plan ahead. To get expert advice, book a call or contact us today for a free mortgage penalty analysis.

FAQ - Breaking a Mortgage Contract and Associated Penalties

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