Prepayment Penalty
Definition
A prepayment penalty is the fee a lender charges when you break your mortgage before the term ends or repay more than your contract allows.
How it works
On a variable-rate mortgage the penalty is almost always three months' interest, which is straightforward and comparatively small. On a fixed-rate mortgage it is the greater of three months' interest or the interest rate differential — the lender's estimate of the interest it loses by re-lending your money at today's lower rate.
Interest rate differential penalties vary enormously between lenders because each uses its own comparison rate. Two mortgages with identical rates can produce penalties thousands of dollars apart, which is why the penalty formula deserves attention before you sign, not after.
Penalties can sometimes be avoided or reduced: by porting the mortgage to a new property, by using your annual prepayment privileges first, by waiting until maturity, or by having a new lender contribute toward the cost.
Quick facts
- Variable: usually three months' interest.
- Fixed: the greater of three months' interest or the rate differential.
- Porting or timing the move can avoid the charge entirely.
Put this into practice
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