Calculating Mortgage Prepayment Penalty
“Prepaying Your Mortgage For Any Reason Is All About The Math Associated
With Doing So”
Most of the time, a borrower will prepay their mortgage through a refinancing process to get a better interest rate.
But there can be other reasons whereby someone has come into additional funds and wants to use all or part of their incremental cash flow to pay down the mortgage balance.
Regardless of the reason, the first thing you need to do before providing funds to your mortgage lender with instructions to apply an amount to the principal balance outstanding is to understand exactly what the costs are going to be to do so.
If you have an open mortgage with a variable interest rate, there is likely not going to be any type of prepayment penalty.
But if you have a fixed interest rate mortgage, you may have to pay a prepayment penalty unless prepayment privileges are provided for in your mortgage commitment and you are staying within the limits of these privileges.
The basic rules around prepayment penalties on fixed rate mortgages is that you will have to pay the greater of interest differential or 3 months interest.
Interest differential is basically the difference in rate between what the lender provided to you when the mortgage was written and what the lender could lend out in the market today, multiplied by the remaining principal and time left on the interest term.
For an example of basic prepayment penalty calculator, here is one you can refer to by clicking the following link … http://www.canadianmortgagetrends.com/canadian_mortgage_trends/interest-rate-differential-ird.html
But the challenge with any type of calculator such as the one provided in the link above, is that they are based on one set of assumptions.
Each mortgage lender can have their own unique twists as to what goes into a prepayment calculation for any particular mortgage.
As a result, there can be large differences between what you THINK the prepayment penalty is based on your own math and what the lender actually calculates it out to be.
This why its important that if you are looking to prepay any amount of principal on your mortgage that you first contact the lender and 1) get their exact prepayment penalty calculation, and 2) their calculation on paper for you of what the penalty will be to you for a given scenario that you outline to them.
With the exact information in hand, you will be in a much better place to make an informed decision about whether or not, for example, a mortgage refinancing for a lower rate is going to be 1) cost effective in the long run, and 2) cash flow affordable in the short run.
In some cases, prepayment penalties can be substantial, so don’t assume you know the math until its verified with the lender.
That way you’re not going to be unpleasantly surprised by a larger than expected prepayment penalty after you’ve committed to refinance your mortgage.
The best way to decide what to do and get any relevant math correct is to work with an experienced mortgage broker who can go through all relevant scenarios with you so you know you’re making the right decision.
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About the Author Joe Walsh
I'm a Toronto Mortgage Broker that arranges mortgage solutions on residential and commercial real estate property. With over 30 years of mortgage financing experience, I'm able to quickly assess your financing requirements and provide relevant solutions for your immediate consideration. Joe Walsh Google+ YouTube Channel