What it costs to break your mortgage

Breaking a mortgage before the term ends costs money. Everyone knows that part. What surprises people is the size, and the fact that two borrowers in near identical situations can face penalties that differ by a factor of ten.

The difference is almost never luck. It is which lender they signed with and how that lender does the arithmetic.

The two calculations

When you break a mortgage early, the lender charges the greater of two figures.

Three months of interest. Exactly what it sounds like. Your balance, your rate, three months. Straightforward to work out and rarely shocking.

The interest rate differential. The lender’s estimate of what it loses by having your money back early and having to lend it out again at a lower rate. Broadly: your balance, multiplied by the gap between your rate and a comparison rate, multiplied by the time left on your term.

On a variable rate mortgage the penalty is typically just three months of interest. On a fixed rate mortgage it is the greater of the two, which in practice means the differential whenever rates have fallen since you signed.

Why the differential can be enormous

Three things drive it, and they multiply together.

• How much is left on the term. Breaking with three years to run costs far more than breaking with eight months. This is the single biggest factor.
• The size of the rate gap. If rates have fallen a long way since you signed, the gap is wide. If rates have risen, there is often no differential at all and you pay the three months instead.
• Your balance. A larger mortgage scales the whole thing up.

The combination is why penalties of tens of thousands of dollars happen. It is not a fee anyone chose to make punitive. It is a calculation that gets very large when all three inputs point the same way.

The comparison rate trick

Here is the part that costs people the most, and it is the reason two lenders can quote wildly different penalties on identical mortgages.

The differential depends on which comparison rate the lender uses. Two broad approaches exist.

Using the discounted rate. The lender compares your rate to what it would actually charge a new borrower today. This is the honest version and it produces a sensible number.

Using the posted rate. The lender compares your rate to its published posted rate, which is a rate almost nobody actually pays. Because you received a discount off posted when you signed, the lender first adds that discount back, which widens the gap artificially and inflates the penalty.

The second approach is common at the large banks. The first is common at monoline lenders. On the same mortgage, the difference between the two methods is routinely thousands of dollars and can be much more.

Nobody hides this. It is in the mortgage documents. It is simply that almost nobody reads the penalty clause when rates are the thing being discussed.

How to find out what yours would be

Call your lender and ask for a payout statement. They are obliged to give you one, it is usually free, and it states the figure as at a specific date.

Two cautions. The figure has an expiry, because it moves as rates move and as your term runs down. And ask specifically how it was calculated, so you can see which comparison rate was used.

If you want to understand the exposure before you are anywhere near breaking, the clause to find in your mortgage commitment is usually headed prepayment or early discharge. We are happy to read it with you.

Ways to reduce it

Wait, if you can. The penalty shrinks as the term runs down. Sometimes waiting a few months saves more than acting now gains. Sometimes it does not, and the arithmetic tells you which.

Use your prepayment privileges first. Most mortgages let you pay down a percentage of the original balance each year without penalty. Doing that immediately before breaking reduces the balance the penalty is calculated on. Our note on paying your mortgage down faster covers how these work.

Port it instead of breaking it. If you are moving rather than refinancing, taking the mortgage with you avoids the penalty entirely. See taking your mortgage with you.

Blend and extend. Some lenders will blend your existing rate with a current one and extend the term, rolling the penalty in rather than charging it up front. Worth asking about, though it deserves a careful look, because a blended rate can quietly cost more over time than paying the penalty outright.

Check whether the savings still justify it. Sometimes they do, comfortably. A large penalty is not automatically a reason to stay put. Work out the break-even: how many months at the new payment before the saving exceeds the penalty. If you will still be there well past that point, breaking can be the right call. Our refinancing page goes through that calculation.

The lesson for next time

The penalty clause matters more than most people believe when they sign, because most people believe they will keep the mortgage for the full term. A large share do not. Jobs move, families change, properties get sold, and equity gets needed.

When you are comparing mortgages, ask two questions beyond the rate. How is the penalty calculated, and which comparison rate is used. A small rate advantage on a mortgage that is expensive to leave is frequently the worse deal, and you will not find that out until the moment it is costly.

If you are weighing whether to break one now, send us the details and we will run the break-even properly rather than optimistically.