When is it Worth Paying a Prepayment Penalty?

With most financial institutions, prepaying a closed mortgage means that you will have to pay a prepayment penalty. A standard prepayment clause may state that the penalty will be "the greater of three month interest, or an interest differential charge."

For example, let's say you have a $100,000 mortgage with three years left to run on the term, at 8% per annum. Three months interest on this amount at 8% is roughly $2000. To calculate the interest differential charge, you need to take into account the lender's three-year rate (because your mortgage has three years remaining on the term) for first mortgages, as of today's date. Let's assume that rate is 6.5%. Your mortgage company would then want to be reimbursed for the difference between their current rate (6.5%) and your existing rate (8%), for the three years remaining. This amounts to roughly 1.5 % a year or 4.5% for three years, for an interest differential charge or roughly $4500.

While this amount is $2500 greater than the three-month penalty, it is often to your benefit to pay this fee. Why?

Very simply, because whether you pay this fee now, or whether you pay it in the form of "additional" interest over the next three years, you'll pay it. To put it another way, a new mortgage at the present (lower) rate, would save you about $4500, completely offsetting the interest differential charge.

Because there are other fees involved in obtaining a new mortgage (i.e., legal, appraisal, etc.) , it is not generally worthwhile to do a straight rewrite. However, there may be other benefits. These may include obtaining a new mortgage for a longer term, or refinancing the mortgage into a larger one, to obtain additional funds, rather than getting a more expensive second mortgage. Another example would be changing to another mortgage company which may be offering a mortgage with more attractive features, such as rate, portability, or assumability.

Therefore, you should recognize that you'll have to pay the extra interest in any event, and make the decision to rewrite or obtain a new mortgage based on the other benefits that you may derive from a new mortgage.

(NOTE: Calculations above have been simplified. Before making a decision to pay off a mortgage, obtain a second mortgage or refinance an existing mortgage for a new one, always obtain a written payout statement form you mortgage holder first. If you require assistance in working out the numbers, please give us a call or apply online for you mortgage.)