There are many reasons why you might want to get out of your mortgage contract early. Maybe the interest rates have dropped, and you want to take advantage of the new rate. Maybe you want to move to a new house. Maybe there’s been a change in your family situation, and the house has to get sold.
Regardless of the reason, most banks will try and charge you a hefty amount for getting out of your mortgage early.
We’re going to talk about what the penalties are for breaking your mortgage, and how to avoid (or at least minimize) them.
What is the Penalty for Breaking a Mortgage
The banks don’t want you to break your mortgage since they would lose the interest payments from you – especially if rates have dropped. Therefore, they make it expensive to cancel your contract.
The most common types of penalties for breaking a mortgage are the Interest Rate Differential (IRD) and straight up three month interest charge.
Interest Rate Differential (IRD). This type of penalty is most commonly used with fixed-rate mortgages. The formula used for calculating the penalty is as follows:
( [The Banks Posted Interest Rate at Time of Signing] – [Current Mortgage Rate] ) x [Mortgage Balance] x [Years Left on Contract]
For example, if you have:
- Original posted interest rate of 3%
- Current interest rate of 2%
- Mortgage balance of $200,000
- 2 years left on your contract
Then the formula would work out to: (0.03-0.02) x 200000 x 2 = $4,000
You can see from the formula that if there is a large interest rate differential, or a large number of years left on your contract then you could be in for some seriously high fees for breaking your mortgage.
Three months of interest. This type of penalty is most commonly used with variable-rate mortgages. The formula for the penalty is:
[Monthly Interest Payments] x 3
For example, if you pay $1,000 a month in interest then your penalty for breaking the mortgage would be $3,000.
If the IRD penalty is less than three months of interest, then the bank will default to charging the three months of interest as the penalty.
How to Avoid a Penalty for Breaking Your Mortgage
The easiest way to avoid the penalties for breaking a mortgage is to just wait until your contractual terms are up.
However, let’s say you want to break your mortgage right now, and avoid as much of the mortgage prepayment penalty as possible.
Here are some popular options:
Porting your mortgage. This only works if you’re getting a mortgage on a new property. You can transfer (or port) your old mortgage over. The bank will cancel your mortgage contract on your old property, and get you a mortgage on the new property. There is usually no penalties for doing this.
Blend and Extend. Blending and extending is basically extending your mortgage term, and blending your old interest rate with the current rate. If the rates have gone down since your original mortgage contract, then this will save you some money. Most banks won’t charge you a penalty if you blend and extend since they’re keeping your business (and interest payments) for a longer period of time.
Blend, Extend, then Cancel. This one is a bit of a dirty trick, but it works. Remember how we said the penalties for breaking your mortgage are interest rate differential (IRD) or three months interest? Let’s say you do the following.
- Blend and extend your mortgage with the bank
- Immediately cancel this new blended mortgage
Since this is a brand new mortgage, then the interest rate differential should by definition be zero on the day you sign it. This means that the bank will default to charging your three months of interest instead.
Only getting charged three months of interest for breaking a mortgage isn’t too bad especially if the current mortgage rates are much lower. Please note that if you do this your bank won’t be very happy with you, but they’ll have to do it nonetheless.
Now you’re free to get a brand new mortgage at the new low interest rate rather than a blended value. Please note that some lenders do have provisions in the contract against this so make sure you read the fine print.
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