When you sign up for a mortgage, chances are the idea of breaking it before your term is up is the furthest thing from your mind.
Although you’re probably most concerned about your mortgage rate, it’s important to ask about mortgage penalties when signing up for with a lender.
There are a lot reasons you may want to break your mortgage early – divorce, job loss, taking advantage of lower mortgage rates, and debt consolidation.
The last thing you want to do is be at the mercy of your bank if one of these happens.
Understanding Mortgage Penalties
When you break a mortgage, it means terminating the contract before its maturity. Open and closed mortgages have different rules for early termination.
Definition of ‘breaking a mortgage’
Breaking a mortgage means you choose to end your mortgage contract early. This happens when you don’t follow the original payment schedule set in the agreement. It can involve paying off the loan quicker than planned, selling your house before the mortgage term ends, or refinancing your mortgage with another lender.
There are different rules for open and closed mortgages when it comes to breaking them.
Open vs. closed mortgages
Open mortgages offer flexibility. They let you pay off your loan early without facing penalties. This means if you come into extra money, you can make larger payments or even settle the entire mortgage ahead of schedule.
Open mortgages are great for people who expect their financial situation to improve quickly.
Closed mortgages are different. They have lower interest rates but come with restrictions on paying off your loan early. If you try to break a closed mortgage, be ready to pay a hefty penalty fee.
These fees exist because lenders miss out on expected interest when loans are paid off early. Closed mortgages work well for those who don’t plan to pay off their mortgage ahead of time.
But first, let’s dive into why someone might decide to break their mortgage contract.
Reasons for breaking a mortgage contract
People break their mortgage contract for many reasons. Often, it’s about finding a better financial situation.
- Interest Rate Fluctuations: Sometimes, interest rates go down after you get your mortgage. You might want to break your current contract to get a new one with a lower rate. This can save you money over time. The general rule of thumb is if the rate is at least 1% lower than your current rate – then it may make sense.
- Home Purchase Necessity: You may need to buy a new home because of a job move or family growth. Breaking your mortgage lets you get into a new house that fits your needs.
- Life Event-Related Sale: Events like divorce or job loss can force you to sell your home sooner than expected. If selling means paying off your mortgage early, breaking the contract becomes necessary.
- Financial Changes: When your finances improve, you might want to pay off your mortgage faster. Or, if money gets tight, switching to a more affordable plan could be best.
Calculating the Cost of Breaking a Mortgage
Calculating the cost of breaking a mortgage involves understanding the penalty for both variable and fixed-rate mortgages. It also includes exploring early renewal options like blend-and-extend to determine the blended interest rate.
Penalty for breaking a variable-rate mortgage
If you have a variable rate mortgage, the mortgage penalty is pretty straightforward – you’ll pay three months’ interest.
This means that if you decide to break your variable-rate mortgage, you will usually have to pay an amount equal to three months’ interest on the outstanding balance of your loan.
To calculate the penalty, you can multiply the outstanding balance by the current interest rate and then divide it by four.
For example, if your remaining balance is $100,000 and your interest rate is 4%, the penalty would be approximately $1,000 (100,000 x 0.04 = 4,000 / 4 = 1,000).
Penalty for breaking a fixed-rate mortgage
If you have a fixed rate mortgage, it’s a bit more complicated – you’ll pay the greater of three months’ interest or the IRD (interest rate differential). This calculates the difference between your original interest rate and the current rate for the remaining term.
Have you ever heard those horror stories of homeowners owing thousands of dollars in mortgage penalties? That was most likely due to the IRD.
The IRD is designed to compensate lenders for lost interest when you break your mortgage early. Although the way lenders calculator the IRD is the same, the comparison rate used differs – it’s important to know ahead of time what the comparison rate is.
Additional costs such as administrative, home appraisal, and discharge fees may also apply.
Breaking a fixed-rate mortgage incurs expenses beyond just the IRD calculation. Remember, additional fees like administrative and home appraisal charges need to be factored into your overall penalty costs when considering early mortgage termination.
Early Renewal Option: Blend-and-Extend
Consider the blended interest rate to extend your mortgage early. This option allows you to combine your current rate with a new one.
How to calculate the blended interest rate
To calculate the blended interest rate, you’ll need to use a weighted average of your existing mortgage rate and the new rate offered for the extended term. Take into account the remaining balance of your current mortgage and apply the new term’s interest rate in the formula.
Remember to consider both the remaining term of your existing mortgage and the term of the new extended mortgage when performing this calculation.
Now let’s explore alternatives to breaking a mortgage, such as porting your mortgage or taking out equity from your home.
Alternatives to Breaking a Mortgage
Consider porting your mortgage to a new property or taking out equity from your home. You can also explore the option of renewing your mortgage early.
Porting your mortgage
Porting your mortgage allows transferring your existing mortgage to a new property, keeping the current terms. It is an option when planning to move and wanting to avoid paying hefty mortgage penalties.
This process enables you to maintain the interest rate and conditions of your original loan while relocating, providing flexibility and potential cost savings.
By porting your mortgage, you can effectively avoid the financial impact of breaking a mortgage contract and secure favorable terms for your new property without incurring additional fees or penalties associated with ending the existing agreement prematurely.
Taking out equity from your home
When considering taking out equity from your home, it’s important to be aware of the associated costs such as administrative fees, home appraisal charges, and mortgage discharge expenses.
It’s crucial to assess whether these additional costs outweigh the benefits of accessing your home equity.
Remember that while taking out equity from your home can provide accessible funds, there are alternatives to consider, like blending and extending with the current lender or porting the mortgage to a new property.
Renewing your mortgage early
Renewing your mortgage early can help you take advantage of decreased interest rates, potentially lowering your monthly carrying costs and allowing for faster mortgage repayment. It also provides the opportunity to lock in lower rates, assisting with budgeting and managing mortgage expenses effectively.
Pros and Cons of Breaking a Mortgage
Breaking a mortgage can lead to lower interest rates and potential money savings. However, it may also result in penalties and fees.
Pros: lower interest rate, saving money
Lowering your interest rate by breaking a mortgage can lead to substantial financial benefits, including reduced borrowing costs and long-term savings. It can result in lower monthly payments, improved cash flow, and an accelerated mortgage payoff.
Refinancing through breaking and renegotiating can lead to monthly savings and increased overall financial well-being.
By negotiating a lower interest rate or refinancing a mortgage, you could potentially reduce your monthly carrying costs and improve your financial position over the long term.
Cons: penalties, fees
Lowering your mortgage interest rate by breaking the contract may seem appealing, but beware of the potential drawbacks. The penalties and fees for breaking a mortgage can include prepayment penalties, administration fees, appraisal fees, and reinvestment fees.
For fixed-rate mortgages, the penalty fee for breaking the mortgage is often significantly higher than for variable-rate mortgages.
Breaking a mortgage entails financial consequences that go beyond just paying off the remaining balance. Be mindful of these costs before making any decisions about terminating your mortgage contract.
Tips to Limit the Risk of Paying a Large Penalty
Research and compare lenders to find the best terms for your mortgage. Choose the right mortgage at the beginning to avoid unnecessary penalties and fees.
Research and compare lenders
When breaking a mortgage, it’s important to research and compare lenders. This can help in finding the lowest prepayment penalty and the best overall terms for a new mortgage. Additionally, exploring alternatives such as porting the mortgage or renewing it early can also be facilitated through researching and comparing different lenders.
Comparing lenders is crucial in minimizing penalty fees when considering breaking a mortgage. By doing this, individuals can find options that align with their specific needs and financial situation.
Furthermore, understanding the penalty fee comparison between different lenders can significantly impact the decision-making process when looking for mortgage renewal options or potential alternatives to breaking a mortgage early.
Choose the right mortgage at the beginning
Selecting the appropriate mortgage type, whether open or closed, is crucial. Closed mortgages offer fewer opportunities for payment flexibility and changes to the payment schedule than open mortgages.
It’s essential to choose a mortgage that aligns with your financial situation and future plans, providing the necessary payment flexibility and early repayment options.
Questions to ask your mortgage broker
Here are some important questions to ask your lender about mortgage penalties before signing up for a mortgage:
What rate do you use for your comparison rate?
It’s a good idea to find out up front if your lender bases your penalty on the posted or discount rate. You may have gotten the discount rate when you signed up for your mortgage, but a lot of lenders base their penalties on the inflated posted rate.
The comparison rate is used when calculating the IRD; the higher your comparison rate, the higher your mortgage penalty.
Will your mortgage lender be more lenient if you break your mortgage and stay with them?
If you’ve ever received a mortgage renewal letter in the mail at the posted rate, you should know how much lenders value loyalty.
Although mortgage lenders may give you a break on your mortgage penalty out of the goodness of their heart, it’s their prerogative.
Mortgage lenders may do this to keep you from going to the competition, whether you receive a break on your penalty will be their call.
Can I refinance my mortgage without paying a penalty?
Whether you’re looking to refinance to consolidate debt, pay for renovations, or use as a down payment for an investment property, it’s important to have financial flexibility.
Your home is most likely your most valuable asset; through a HELOC (home equity line of credit) you can tap in and withdraw up to 80 per cent of your equity.
When you refinance, you break your existing mortgage to get a new, larger mortgage. If your HELOC is with your existing lender, your lender may only charge you the admin fees of setting up your HELOC, but you can still face hefty mortgage penalties if your lender isn’t as lenient as you’d like.
Conclusion
Breaking a mortgage can result in prepayment penalties. Closed mortgages may have penalties, while open mortgages provide more flexibility. Consider alternatives like porting or renewing to avoid additional fees.
Evaluate the terms carefully before breaking a mortgage contract. Be mindful of changes in interest rates and financial situations when considering this option.
