When you pay a penalty
A closed mortgage is a promise to borrow a set amount at a set rate for a set term. Paying more than your prepayment privileges allow before the term ends breaks that promise, and the lender charges a prepayment penalty. That happens when you:
- sell your home and don't port the mortgage to the next one,
- refinance to borrow more or get a lower rate,
- switch lenders before maturity, or
- pay off a large chunk beyond your annual lump-sum limit.
At maturity there's no penalty. Your term has ended and you're free to pay off, renew or switch.
Variable rates: three months' interest
Most variable-rate mortgages charge three months' interest and nothing more. The math is simple:
penalty = balance × annual rate × 3 ÷ 12
On a $350,000 balance at 4.99%, that's $4,366. Predictable, and usually modest.
Fixed rates: the greater of two numbers
Fixed-rate mortgages typically charge the greater of three months' interest or the interest rate differential (IRD). The IRD tries to cover the lender's loss: they lent you money at your rate, and if rates have fallen, they can only re-lend it at a lower one for the rest of your term.
IRD = balance × (your rate − comparison rate) × months remaining ÷ 12
When rates have risen since you signed, the comparison rate is higher than yours, the IRD is zero or negative, and you pay three months' interest. When rates have fallen, the IRD can be several times larger.
The comparison rate is everything
Lenders don't all choose the comparison rate the same way, and that choice is where penalties balloon.
Method 1: the current discounted rate
The lender compares your rate with the rate it's actually offering today for a term close to your time remaining. Many monoline lenders, which lend only through mortgage brokers, use a version of this method.
Method 2: the posted rate minus your original discount
Many big banks use their posted rates, which are higher than what almost anyone actually pays. When you signed, you got a discount off the posted rate. To calculate the IRD, the bank takes today's posted rate for the remaining term and subtracts that same original discount. Because posted rates and actual rates don't move together, this often produces a much lower comparison rate, and a much bigger penalty.
Worked example: same mortgage, two lenders
You signed a five-year fixed at 4.99%. At the time, the bank's posted five-year rate was 6.49%, so your discount was 1.50 points. Now you owe $350,000 with 30 months (2.5 years) left.
| Discounted-rate method | Posted-rate method | |
|---|---|---|
| Comparison rate | 4.29% (today's offered rate) | 5.49% posted − 1.50% = 3.99% |
| Rate gap | 0.70 points | 1.00 point |
| IRD | $6,125 | $8,750 |
| Three months' interest | $4,366 | $4,366 |
| Penalty charged | $6,125 | $8,750 |
Same balance, same rate, same time remaining, and a $2,625 difference purely from the method. When posted and actual rates drift further apart, the gap can be far larger.
Decoder ring: "posted rate"
A posted rate is a lender's advertised list price. Hardly anyone pays it. Its main job in practice is to feed penalty calculations. When a lender's contract mentions the posted rate in its prepayment section, read that section twice.
How to find your actual penalty
- Read the prepayment section of your mortgage contract. It describes the method and the comparison rate.
- Use your lender's online penalty calculator. Most federally regulated lenders provide one.
- Call and ask for a written penalty quote as of a specific date, and ask which comparison rate and which term were used. Penalties change daily as balances and rates move.
Seven ways to reduce or avoid a penalty
- Wait for maturity. If you're within a few months, waiting is often cheaper than any penalty.
- Make your annual lump-sum prepayment first. It reduces the balance the penalty is calculated on. Some lenders let you do it the same day you break.
- Port the mortgage to your new home if you're buying and selling. Check the porting window, often 30 to 120 days.
- Blend and extend with your current lender. No upfront penalty, though its cost is folded into the blended rate.
- Let the buyer assume your mortgage, if your contract allows assumption and your rate is attractive.
- Ask the new lender whether they'll cover part of the penalty to win your business. Some will, especially on larger balances.
- Choose your next mortgage with the penalty in mind. If there's a real chance you'll sell or refinance within five years, a lender that uses the discounted-rate method, or a shorter term, can be worth more than the lowest rate.
Is breaking still worth it?
Sometimes, yes. If rates have dropped far enough, the interest you'll save before your term would have ended can exceed the penalty. The only way to know is to run the numbers with your real penalty. Use the refinance break-even calculator, or worksheet B-4 from the free worksheet pack.