What is a prepayment penalty?
Paying off your mortgage early? This hidden fee could cost you thousands — what is a prepayment penalty?
What is a prepayment penalty?
A prepayment penalty is a fee your lender charges if you pay off your mortgage or refinance before the agreed term ends. It’s the lender’s way of recouping lost interest. Simple: you leave early, the lender loses income, you pay a penalty.
Why lenders use prepayment penalties
Lenders price loans based on interest they expect to earn. When you pay early, they can’t collect that income. Penalties protect lenders and keep fixed-rate mortgages cheaper for everyone.
Common types of prepayment penalties
- Interest Differential (IRD): Common in Canada for fixed-rate, it compares your mortgage rate to current rates and charges the difference on your remaining balance. This can be costly when rates have dropped since you signed.
- Three-month interest: Often used for variable-rate mortgages. The penalty equals three months’ interest on the outstanding balance.
- Flat fee or percentage: Some lenders charge a fixed amount or a percentage (e.g., 1–3%) of the remaining mortgage.
Quick example (simple math)
You have $300,000 outstanding at 3.5% fixed with 3 years left. Rates now are 2.5%. An IRD could charge the difference on the remaining balance over the remaining term — that can easily be several thousand dollars. A three-month interest penalty on the same balance at 3.5% would be about $2,625 ÷ 4 = ~$656 (three months’ interest).
How prepayment penalties connect to liens and closing mortgage accounts
A mortgage is a lien on your property. Paying it off removes that lien. But the lender can require the penalty before they discharge the lien. Always confirm payoff figures in writing so the lender will remove the lien once the penalty and balance are cleared.
How to avoid or reduce a prepayment penalty
- Choose an open mortgage or one with generous prepayment privileges.
- Negotiate terms up front. Lenders expect questions. Ask for lower penalties or capped IRD.
- Time a refinance at the end of your term when penalties are gone.
- Port your mortgage if you move; this can avoid triggering a penalty.
- Use a mortgage broker to compare lenders—penalty rules vary widely.
What to check now
- Read your mortgage contract: penalty clause, prepayment privileges, and how penalties are calculated.
- Ask for a written payoff statement before you refinance or sell.
- Consult a mortgage expert or real estate lawyer if numbers don’t add up.
If you want a clear payoff estimate, help negotiating penalty terms, or guidance on avoiding costly fees when selling or refinancing in Toronto and the GTA, contact Tony Sousa. He’s a local expert on mortgages & liens and will translate lender language into an actionable plan.
Email: tony@sousasells.ca | Phone: 416-477-2620 | https://www.sousasells.ca
