Many closed mortgages have a built-in feature that allow you prepay an extra 10 to 20 percent of principal each year, but if you go beyond that amount (whether through a lump-sum payment, a refinance or the sale of your home), you could be subject to prepayment penalties. This compensates your lender for the interest they would have received had you continued paying your mortgage as originally scheduled.
Prepayment penalties are typically equal to three month’s interest on your current mortgage or the interest rate differential, whichever one is higher. The interest rate differential (or IRD) equals the difference between your current mortgage rate and the rate that your lender could charge in present day by relending funds for the remaining term of the mortgage. When prepaying your mortgage, you may be subject to administrative or legal fees on top of the IRD penalty.
But prepayment penalties don’t apply to every situation. Here are a few instances where you may be able to avoid prepayment penalties and potentially save thousands of dollars:
- Payment at maturity – When you reach the end of the term in a closed mortgage, you can pay off your mortgage balance in full or part without penalty.
- Assumption of an existing mortgage – You can avoid penalties if you’re selling your home and the buyers assume your existing mortgage. The buyers would have to qualify for your mortgage and accept the same terms, conditions and maturity date. However, there may still be legal costs associated with the transaction.
- Porting your mortgage to a new home – Some mortgages have portability, meaning you can move the mortgage to a new home and keep the same interest rate, balance amount and maturity date. However, you would need to close on your previous property and the new one within 90 days. If you’re upgrading to a more expensive property and need to borrow additional money, you may still be able to get a blended mortgage that combines the old interest rate with the new one.
- Renew your mortgage within 90 days. You can typically renew your mortgage within 90 day of your current loan’s maturity date. Longer than that and you’ll likely pay a prepayment penalty.
Prepayment penalties can be confusing, so talk to your bank or your mortgage lender if you need help calculating your penalty prepayment penalty or figuring out if it would apply to your circumstance. Several banks have online prepayment penalty calculators on their websites.