Your mortgage needs may change before the end of your mortgage contract. If that happens, you’ll probably have to break your mortgage — and pay a penalty for the privilege of doing so.
How much you’ll owe in prepayment penalties depends on several factors, including the type of mortgage you choose and the remaining length of your mortgage term. Understanding the costs, as well as the potential benefits, of breaking a mortgage can help you make better long-term decisions regarding your home loan.
What does ‘breaking a mortgage’ mean?
First off, breaking a mortgage does not mean you stop making mortgage payments. Breaking a mortgage means breaking the terms of your mortgage contract.
When you sign a mortgage contract, you agree to a strict payment schedule for a set term. If you change the conditions of your mortgage or leave your contract before the end of the term, you’re breaking your mortgage.
Open vs. closed mortgages
Typically, if you‘re charged a penalty for breaking a mortgage, it’s because you’ve opted for a closed mortgage.
A closed mortgage offers few opportunities to make changes to your payment schedule; lump-sum and additional payments may be possible, but they’ll be capped at a certain percentage of your mortgage amount. If you sell your house during your mortgage term and pay off your mortgage early, for example, you’ll be penalized for going over your pre-payment threshold.
Because they give you less control over your mortgage, closed mortgages often come with far lower interest rates than open mortgages, which allow you to pay back your mortgage ahead of schedule without incurring any penalties.
Reasons for breaking a mortgage contract
A lot can happen during your mortgage term that would require you to break your mortgage. Sometimes a life event occurs and breaking your mortgage is your only option, even if it might be costly. Other times, breaking a mortgage may actually save you money.
You might decide to break your mortgage contract if:
- Interest rates have dropped. Getting a new mortgage could lower your overall costs even with the prepayment penalty factored in.
- You want to buy a new home. For those looking to upgrade their home, a new mortgage would likely be needed.
- You need to sell. A divorce, new job or a loss of income could trigger a need to sell your home early.
- Your finances have changed. Some people choose to refinance their mortgage with a longer amortization period if they need a lower monthly payment. Alternatively, you may decide to pay off your mortgage early if you’ve received a windfall or gotten a raise.
The cost of breaking your mortgage
If you’re breaking a closed mortgage, the amount of your prepayment penalty will depend on whether you have a variable-rate or fixed-rate mortgage.
The penalty for breaking a variable-rate mortgage
Variable-rate mortgages, which have interest rates that change based on a lender’s prime rates, typically have a straightforward penalty of three months’ interest.
The relatively modest penalty associated with breaking variable-rate mortgages can make them attractive when variable rates are low, or if a home buyer feels they may not stay in their home for the full mortgage term.
The penalty for breaking a fixed-rate mortgage
Fixed-rate mortgages, which keep the same interest rates for the entire length of a mortgage term, typically use an interest rate differential (IRD) to calculate the penalty.
Lenders may have their own IRD calculations, but they generally look like this :
- Your lender finds a mortgage product with a term length similar to your remaining mortgage term. If you have a five-year, fixed-rate mortgage with two years left, for example, your lender will consult its current offerings of two-year, fixed-rate mortgages.
- The interest rate of that product is subtracted from your original interest rate. If your lender’s two-year, fixed mortgage rate is 4%, and your original rate was 5%, the IRD rate will be 1%.
- That number is then multiplied by your remaining balance and divided by 12, which determines your monthly amount owing. If you have $400,000 left on your mortgage, this figure would be about $333.
- That number is then multiplied by the months remaining on your term. In this example, that’s 24 months, so you’d be looking at a prepayment penalty of about $8,000.
Regardless of whether you have a fixed- or variable-rate mortgage, there may be additional costs to factor in, such as administrative, home appraisal and discharge fees. If your lender offered you cash back, you might also need to repay a portion of that, too.
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Is breaking a mortgage a good idea?
There are times when breaking a mortgage can be beneficial.
If mortgage rates drop significantly, for example, you may want to contact your lender or mortgage broker about breaking your mortgage and refinancing at a lower rate. To be worth it, the interest savings have to be greater than the prepayment penalty.
If your local real estate market catches fire and buyers are making wild offers, it might also be worth breaking your mortgage to sell and come away with an unexpected windfall. Again, you’ll need to know the penalty you’ll pay before deciding if selling early will be profitable.
But breaking a mortgage can be an expensive proposition, particularly if you have several years left on a closed, fixed-rate mortgage. Unlike mortgage default insurance, which can be paid off over years, you’ll be expected to pay your prepayment penalty all at once. That can knock a hole in the proceeds of a home sale and even interfere with buying your next property.
If you break your mortgage to score a better deal with a different lender, remember that you’ll have to pass another mortgage stress test before getting your new mortgage approved. If mortgage rates have risen since you started paying off your current mortgage, you’ll have to pass the stress test at a higher minimum qualifying rate.
Pros and cons of breaking a mortgage
Everyone has different reasons for breaking a mortgage, so you need to look at your individual situation before deciding to do it. That said, there are some general pros and cons to think about.
- You’ll pay less interest over the term
- Lower monthly carrying costs
- You could pay off your mortgage faster if you kept your payments the same
- Locking in lower rates can help you budget
- You’ll need to pay penalty fees
- You’ll need to repay a percentage of any cash back received
- You might end up paying more once your factor in any fees paid
- New mortgages require you to pass the stress test
Alternatives to breaking your mortgage
Unless you have an open mortgage, it’s nearly impossible to avoid the fees associated with breaking a mortgage. Still, you may have the option to:
- Blend and extend. Some lenders will allow you to blend your existing fixed-rate mortgage with current rates if you extend your term. This won’t be an option if you have to sell or want to move to a new lender.
- Port your mortgage. This is where you purchase a new home and your lender allows you to apply your existing contract to another property.
If breaking your mortgage feels like the right thing to do, contact your lender to find out more about the process and any potential fees. If you’re moving to a new lender, get in touch with them early and ensure everything is handed off correctly.
Frequently asked questions about the penalty for breaking a mortgage
If you break a variable-rate mortgage, you’ll typically pay a penalty equal to three months’ interest. If you break a fixed-rate mortgage, your lender will likely determine how much you owe based on their interest rate differential (IRD) calculation. Typically, you’ll pay the greater of the IRD amount and three months’ interest.
Breaking a mortgage means renegotiating your home loan before the end of your term, so yes, you can do that — if you’re willing to pay the fees and penalties that come with it. Breaking a mortgage is not the same as stopping your mortgage payments.
Mortgage renewal is an opportunity at the end of a mortgage term to negotiate the conditions of your contract, such as the interest rate, payment schedule and more.