What are pre-payment penalties?

If you're in the market for a mortgage, it's important to understand all the terms and conditions that come along with it. One term that you will probably come across is "pre-payment penalty." This is a fee that some lenders charge if you pay off your mortgage loan before a certain period of time has passed. 

While pre-payment penalties can be a useful tool for lenders to protect themselves against potential losses, they can also be a source of confusion and frustration for borrowers. So it’s important to know all the details in your mortgage contract, before signing on the dotted line. 

What is a pre-payment?

A pre-payment means paying more than your regular mortgage payment, either as a lump sum or as increased regular payments. In general, you can provide a pre-payment on your mortgage at any time, as long as your mortgage contract allows it. 

By making pre-payments, you can reduce the amount of interest that you pay over the life of your mortgage or even pay off your mortgage sooner.

For example, let's say you took out a $300,000 mortgage for 30 years at 4% interest. Your monthly payment would be around $1,432 (not including taxes and insurance).

If you make all your regular payments for the full 30 years, you'll end up paying a total of $515,608, with $215,608 going towards interest!

But, if you decide to add an extra $500 to your monthly payment, you can pay off your loan faster and reduce the total interest you pay. If you keep up with the extra $500 every month, you'll end up paying a total of $439,012, with only $139,012 going towards interest!

By adding that extra $500 each month, you could save $76,000 over the life of your loan.

However, some mortgage contracts may have restrictions on pre-payments, such as limiting the amount of pre-payment you can make or only allowing pre-payment on specific dates or in specific amounts. Additionally, some mortgages may have a pre-payment penalty, which is a fee charged by the lender for paying off the mortgage early.

What are pre-payment penalties?

Basically, this is a fee that your lender might charge you if you pay off your mortgage before a certain amount of time has passed (usually within the first five years of your term).

The idea behind this fee is that lenders want to make sure they're getting their money's worth for lending you the cash to buy your home. By paying off your mortgage too quickly, they might lose out on some interest they were expecting to earn over the years. So, the pre-payment penalty is a way for them to recoup some of that potential loss.

Now, the thing is, not all mortgages come with pre-payment penalties. And even if they do, the amount you'll be charged can vary depending on your lender and your specific mortgage agreement. So, it's important to read the fine print and understand what you're signing up for before you agree to any mortgage terms.

That said, if you're able to make pre-payments on your mortgage without incurring any penalties, it can be a great way to save some serious cash in the long run. By paying off your mortgage faster, you'll reduce the amount of interest you have to pay overall, which can be a huge win for your wallet.

How much are pre-payment penalties? 

Pre-payment penalties on mortgages in Canada can vary depending on a few factors such as the type of mortgage you have, as well as the interest rate you’ve chosen, and the lender, and the terms of your agreement. In general, pre-payment penalties can range from a few months' worth of interest to a percentage of the outstanding balance of your mortgage.

If you have a variable-rate mortgage, you’ll generally owe three-months’ worth of interest as your payment. However, when it comes to mortgage pre-payment penalties for fixed-rate mortgages, the interest rate differential (IRD) is used to calculate how much you'll need to pay.

The IRD amount is calculated by taking the difference between the interest rate on your existing mortgage and the current interest rate that your lender could charge for a new mortgage with a term similar to your remaining mortgage term. The lender then multiplies this difference by the number of months remaining in your mortgage term and the outstanding mortgage balance.

So, in other words, the pre-payment penalty for breaking your fixed-rate mortgage early is often calculated based on how much interest the lender will lose out on if you pay off your mortgage before the end of the term. The longer you have left on your mortgage term and the larger the difference between your existing interest rate and current rates, the higher the pre-payment penalty is likely to be.

It's important to note that pre-payment penalties are typically meant to discourage you from paying off your mortgage early and can be a bit of a bummer if you're looking to save on interest or pay off your mortgage sooner than expected. That said, if you're in a situation where you're considering paying off your mortgage early, it's always a good idea to check with your lender to see what the pre-payment penalty would be in your particular case.

It helps to calculate ahead too, before making any decisions, so you’ll have a better idea of how much you might have to pay.

How do you know if your mortgage has pre-payment penalties?

Before signing a mortgage agreement, it's important to read the fine print and understand the terms of your mortgage. Your mortgage contract should clearly outline whether or not pre-payment penalties apply, and how they are calculated.

If you're unsure whether or not your mortgage has pre-payment penalties, you can contact your lender directly and ask. They should be able to provide you with the information you need.

In the end, buying a house and paying off a mortgage can be a complex process, but by understanding the terms of your mortgage and making informed financial decisions, you can achieve your homeownership goals and secure your financial future. 

Of course if you have any questions, feel free to fill out Pine’s quick and easy application and we’ll be happy to connect you with a mortgage agent to answer any and every one of your questions.