How are prepayment penalties calculated?
By ATB Financial 29 March 2021 1 min read
What is a prepayment penalty?
A prepayment penalty is a sum of money paid to your lender (like your bank) if:
- You decide to payoff or renew the mortgage before the end of its term, and/or
- You pay down the mortgage more than allowed by the mortgage contract.
The prepayment penalty is only applicable to closed-term mortgages (not open-term mortgages).
Prepayment penalties can be calculated in two different ways, depending on the type of mortgage you have, as well as the amount of time left on your mortgage term.
The two main types of mortgages:
1. Fixed-rate mortgage
In a fixed-rate mortgage, the interest rate doesn't change over the term of your contract. That means your interest rate and mortgage payments are constant for your mortgage term.
2. Variable-rate mortgage
In a variable-rate mortgage, the interest rate is based on your bank or financial institution's prime lending rate. A variable rate will be usually quoted as Prime plus or minus a specified percentage, such as "Prime + 0.15%" or "Prime - 0.25%". Though the prime lending rate may change, the mark-up or mark-down from Prime will stay constant over your term.
If you don't know what kind of mortgage you have, take a look at your Annual Mortgage Statement (which you should get in the mail every January).
If you have a fixed-rate mortgage
The prepayment penalty is either three months' interest OR the value of the Interest Rate Differential (IRD) for the remaining term of your mortgage (whichever is greater).
The Interest Rate Differential (IRD) is the difference between your existing interest rate and the comparison rate.
The comparison rate is the current Posted Interest Rate (that is, the standard, non-discounted annual interest rates applicable to residential mortgage loans that are announced or published by ATB) for a fixed rate mortgage with a term closest to the term remaining on your mortgage reduced by any rate discount you may have received off of ATB’s posted interest rate when you entered into the mortgage. (So, if you have three years left in your term, your existing mortgage rate would be compared to ATB's current Posted Interest rate for a three-year fixed mortgage.)
This difference is then multiplied by the mortgage balance and residual term.
Check out Good Advice for more helpful information about home-ownership and mortgages.