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Good To Know: Understanding Mortgage Prepayment Charges

Interest rates are at historical lows. It’s no secret. So you might be tempted to consider renegotiating your mortgage to take advantage of them.

But be warned, if you break your closed term mortgage, you will be assessed a prepayment charge.

We know what you’re thinking right now: A WHAT?!

On that note, let’s break down how these mortgage prepayment charges work…

Why does a closed-term mortgage have a prepayment charge?

A prepayment charge is intended to reimburse the lender for the economic costs it incurs when a prepayment amount exceeds the prepayment privileges permitted under the mortgage. Included in this total are prepayment transaction costs, plus the full term amount of interest that was designed, in part, to acquire the mortgage which the lender will not recover when a mortgage is prepaid.

How do you calculate the prepayment charge for a mortgage with a closed variable rate?

Easy. The prepayment charge is three months’ interest on the amount prepaid using the interest rate if you have a variable rate mortgage.

How do you calculate the prepayment charge for a closed fixed rate mortgage?

The prepayment charge for a fixed-rate mortgage is the greater of three months’ interest on the amount prepaid at the interest rate. Or, the interest for the remainder of the term on the amount prepaid, calculated using the interest rate differential (IRD).

What is this interest rate differential you speak of?

Good question. The IRD is the difference between the interest rate and the lender’s posted rate on the prepayment date for a mortgage with a term similar to the time remaining in the term, and having the same prepayment options as the mortgage less your rate reduction.

What about the concept of ‘present value’ I’ve heard about? Is it a component of completing the calculation of a prepayment charge for a closed fixed rate mortgage?

Sure is. This ‘present value’ concept recognizes that interest income to be received in the future is less valuable than the same amount of money received today. The interest rate differential calculation also takes into account the fact the mortgage balance for the remaining term declines on each payment date.

But is this concept useful?

You bet. The use of these financial concepts in the calculation reduces the amount calculated using the interest rate differential.

Can the prepayment charge change?

A prepayment charge certainly can change over time.

But how?

There are a few reasons. As the number of months or days remaining in the term of the mortgage changes with each day, it is possible for the ‘similar term’ mortgage used for comparison purposes in the interest rate differential calculation to also change. Also, because the interest rate differential calculation is based on the difference between the interest rate and our posted interest rate on the requested payout date, if the posted rate changes, the interest rate differential calculation will also change.

What if a different payout date is requested?

If that’s the case, it is traditionally possible to have a prepayment charge using the three months’ interest method change to a prepayment charge using the interest rate differential calculation or the reverse because of the factors noted above.

Thank you!

No problem. That’s what we’re here for. Any additional questions? Contact The Lang Team. With over 60 years of combined experience in banking, financial services, and home financing advice, The Lang Team is uniquely positioned to help you achieve your real estate financing goals.