An open mortgage term does not have a pre-payout penalty. Therefore, an open mortgage carries a premium on interest rate to ensure that the financial institution is able to recover as much interest as possible for the duration of the term.
A closed mortgage has some restriction on early pre payments. When you pay off your mortgage before the end of the term, or make a lump sum payment greater than the percentage permitted, you will be charged a pre-payment penalty.
Some mortgages are absolutely closed for the term of mortgage and cannot be paid out at all. There mortgages are offered through some lenders. Borrowers are allowed to payout the mortgage under bona fide sale condition. These mortgages have Bona–Fide sales clause in the contract. This means that you can only pay out the mortgage if you sell your property.
Again, it is very important that you have a full understanding of the consequences of all options and read your contract carefully.
There are different methods of calculating a mortgage pre-payment penalty but the standard for a variable mortgage is 3 months interest penalty and on a fixed mortgage, 3 months interest or IRD whichever is higher.
It is the later method that usually gets borrowers confused. We hope we can clarify it for you in this blog post.
Variable Rate Mortgage Rule of Thumb
In Canada almost all variable rate mortgages use the 3-month interest rate penalty calculation rule. It’s solely based on having a 3-month penalty at your existing mortgage rate on the principal amount owing at the re-payment date.
Here’s how it works, if you have a $300,000 mortgage at 4% the penalty would be $2975.31. Here’s how it works:
- Total Mortgage amount to be paid out = $300,000
- Interest rate = 4.00
- Your 3-month penalty would be= 991.77*3= 2975.31
Interest Rate Differential Penalty
“The interest rate differential is the difference between the contract interest rate and current bank rate, on the date that the mortgage is paid out, on a term similar to the remaining term, calculated on the total outstanding balance”.
Once the figure is determined, the bank calculates the 3 months penalty and compares it with the IRD figure and charges whichever was higher. Here is an example:
Mary had a mortgage of 300,000.00 with a rate of 4% and a 5 year term in 2010.
In 2013 she decided to sell the property and payout the mortgage in full.
There is 2 years remaining on her contract and the her bank’s rate for 2 year is 3.2%
When Mary cancels her contract with the bank and pays out a mortgage with 4% rate, the bank would have to reinvest the funds at 3.2%. THE BANK IS LOSING MONEY.
The bank will calculate the difference in interest rate (4-3.2= .80) on 250,000.00 for the two years remaining on the term of the mortgage contract. If that figure is higher than 3 months interest on 250,000.00, that would be the penalty.
* Not all IRD’s are calculated using above method. Some lenders may use a slightly different method but the most standard is as above.