What is a Mortgage Prepayment Charge?

When applied to mortgages, prepayment refers to the cost associated with breaking a mortgage term before it completes. Mortgages come in two main varieties; open and closed term.

When speaking of prepayment costs, it refers to a closed-term mortgage, which can be either variable or fixed rate terms. Breaking a closed-term mortgage will have prepayment costs, unlike an open-term mortgage.

To calculate any potential costs associated with breaking a closed-term mortgage, you need to figure out a couple of things.

The first thing is to determine if you have a variable or fixed-rate mortgage. Once that’s determined you will need to figure out how long of a term you have left on your existing mortgage. Finally, you need to identify the current posted rate based on the remaining years left on your mortgage, which will be used to calculate what’s known as interest rate differential (IRD).

I will go over the variable option first as it’s the easier of the two to calculate. Most lenders will allow you to break a closed-rate variable mortgage at no cost with one catch. You have to lock into a new 5-year fixed-rate mortgage based on the current market rate.

If that option isn’t feasible for you, then the lender will charge you the greater of 3 months of interest or interest to maturity if you have less than three months left on your term. For example, Ms. Tokyo has a current mortgage outstanding balance of $100,000 on a closed variable 5-year mortgage at 2.90% after six months into the mortgage. She wants to break her mortgage as she’s moving away for work and will sell her property.

How to Calculate Variable-Rate Prepayment Mortgage Cost

Ms. Tokyo will have a total prepayment mortgage cost of $720.66 based on an outstanding mortgage balance of $100,000  on her closed variable mortgage if she breaks it six months after signing the mortgage. Below is how you would calculate the prepayment cost for her mortgage.

Prepayment Variable Rate Mortage Formula Calculation:

Oustanding Mortage Balance*Contract Interest Rate (monthly)*Number of Months (since this is variable it would be three months or less)

$100, 000.00*0.002402*3= $720.66 (rounded up)

When it comes to variable rate mortgages, you will pay at most three months of interest if you decide to break the mortgage before the term is up. A variable mortgage can be a good option for keeping your prepayment cost low compared to a closed fixed-rate mortgage.

How to Calculate a Closed Fix-Rate Mortgage Prepayment Cost

Fixed-rate mortgages are not as straightforward. The calculation of prepayment costs is complicated as each lender might calculate things slightly differently. In fact, most lenders don’t even bother doing manual calculations and simply rely on computers to calculate the correct prepayment costs. The key to calculating the cost is figuring out the interest rate differential.

For example, let’s assume you have an existing fixed rate mortgage at 2.90% for five years but wish to break it one year later. The current 4-year fixed rate posted by your lender is 4.75% as there are four years remaining on your term, giving you an interest rate differential of 2% (4.90-2.90).

Let’s continue with Ms. Tokyo, but her mortgage is fixed this time. She still has a mortgage for $100, 000.00 with a current rate of 2.90%. She breaks her mortgage six months later, which means she has four years and six months left on her current term and the current posted four years posted rate is 4.90% for her lender. Below is the formula along with the solution.

Fixed Rate Mortage Prepayment Formula Calculation:

Current Oustanding Mortage Balance*Interest Rate Difference (monthly)* Number of Months Remaining for Mortgage Term

$100, 000.00*0.001660 *54=$8,962.73 (rounded up)

As you can see, the prepayment cost is much higher than the variable-rate mortgage. Part of the reason why the fixed rate prepayment cost is greater is due to the lender losing out on interest income compared to a variable rate mortgage. When a lender has a variable rate mortgage, they are not at risk of being underpaid because the interest rate they have charged is lower than a similar term mortgage term. Variable rate update according to market rates means lenders are less likely to be in a position where the rate they are charging is much lower than what they could charge on a similar loan if they were to lend again.

On the other head, a fixed rate mortgage locks the lender into whatever rate they agreed upon at the time, and if the interest rate goes up, the lender actually loses money as they could charge a higher interest rate for that loan but are unable to as they have locked in the rate.

How to Reduce Mortgage Prepayment Penalty?

The best way to reduce the prepayment penalty is to spend enough time assessing your situation before you sign the mortgage document. If you think you might sell your home or you believe you might come into a large sum of money to pay off the mortgage early, selecting a variable closed or an open mortgage would be best. The open mortgage will have a higher interest rate, but by selecting a variable closed mortgage, you can at least cap the amount of prepayment penalty you will have to pay.

If you are in a fixed-rate mortgage, you might want to discuss a blend and extend option with your lender. A blend and extend is where the lender takes the current market mortgage rate for the term remaining on your mortgage and blends it with your existing rate to come up with a new rate that ensures the lender doesn’t lose money while reducing the penalty cost to you.