How to Get Out of a Mortgage Without a Penalty
Mortgages are a big commitment. The mortgagor – your lending institution – is committed to providing you with a comprehensive mortgage product with an affordable rate. As the mortgagee, you are committed to making your monthly payments on time while working towards paying off your principal.
Both you and the lender are legally bound to the mortgage from the time you sign the contract to the expiration of the term, after which you must renew it if there is still a balance left to be paid. But there are cases where you may consider breaking your mortgage contract.
As stipulated in your mortgage contract, you may be required to pay a penalty if you break from your mortgage contract early. This penalty can potentially set you back several thousand dollars. But how exactly can you get out of a mortgage without a penalty, and if so, is it worth it? Read on to find out.
Should you break your mortgage contract?
Many things can change during the term of your mortgage contract. You might lose employment, fall ill, sell your home or need to move for a new job. All of these scenarios can have positive or negative implications on your financial situation. You may also realize that the structure of your current mortgage product no longer fits with your personal needs as a result of these changes.
Another reason for breaking your contract is the desire to switch to a different lender because of a drastic change in interest rates that no longer make your current mortgage rate worth sticking with. In this case a cost benefit analysis of your penalty costs against the savings from a new lower rate mortgage might help answer your question. Some people wait until their mortgage is up for renewal before they switch lenders, as they won't incur a penalty at that point. Others may not be willing to wait that long due to urgent circumstances or the mortgage product itself.
Read the fine print
In theory, signing a mortgage contract is as simple as signing on the dotted line and agreeing to a posted interest rate and regular monthly payments until the principal is paid off. But there is much more to the process, and it could prove to be challenging to someone inexperienced. But regardless of your experience, simply signing the contract without understanding the terms first could lead to surprise penalty charges if you choose to break the contract later on.
While understanding legalese can seem like a chore to some, it can come in handy in certain situations. In a situation where large amounts of money are changing hands, it’s important to arm yourself with all the required knowledge beforehand as a means of protecting yourself. If necessary, review the mortgage contract with a lawyer before you sign it.
How much is the penalty?
The amount of the penalty tends to differ from one lender to the next. A number of online penalty calculators exist, but you can calculate it by yourself ahead of time. This way, if you’re ready to get out of your mortgage contract, you’ll know how much you’ll have to pay before it becomes an issue.
Generally, there are two common ways many lenders use to calculate how much your penalty will be. When issuing the penalty, the lender may apply the higher value of the following two calculations:
- Three months’ interest: The combined value of your next three mortgage payments’ interest.
- Interest rate differential (IRD): The rate of the number of years remaining on the mortgage, subtracted from your original interest rate and then multiplied by the balance.
There may be other costs associated with breaking your mortgage contract, including:
- appraisal fees
- reinvestment fees
- administration fees
- a prepayment penalty
- a fee to remove charges on your current mortgage product and register a new one
In some cases, the lender may agree to reduce the amount of the prepayment penalty if you plan to exit your existing mortgage contract and then begin a new one with the same lender.
How to calculate the mortgage penalty
Three months’ interest
As previously mentioned, lenders always apply the greater of three months’ interest or the IRD when determining what your mortgage penalty will be. In order to calculate the value of three months’ interest, we will use the following scenario.
You are considering cancelling your mortgage contract with your current lender. At the time of cancellation, you have a balance of $300,000 remaining on your mortgage – a five-year fixed-rate mortgage with a rate of 3.5%. Let’s assume that you are two years into the term of this mortgage and that interest rates have not changed from the time you first signed the contract to the present day.
To determine the cost of three months’ interest, we will use this calculation method:
(Interest Rate ÷ 100) × Remaining Balance × (Months ÷ 12)
(3.5% ÷ 100) × $300,000 × (3 ÷ 12) = $2,625
In this example, 3.5% (0.035) multiplied by your remaining principal is $10,500. We then multiply that amount by three months, which gives us $31,500. Dividing 3 months by 12 month yield 0.25, which is then multiplied by $31,000 to gives us a final answer of $2,625, which would be the value of a three months’ interest penalty.
Interest rate differential (IRD)
If your lender opts to use the IRD variant, they compare the difference between the rate you obtained at signing and the present rate that best matches with the term remaining on your mortgage. Given your initial rate of 3.5% and that you have three years remaining on your term, let’s assume the three-year fixed rate is 3%. The difference between the two rates is 0.5%.
Your lender will then take that difference and multiply it by your remaining balance and the term remaining on your mortgage. In the calculation below, this is shown as the months remaining divided by 12.
(Rate Difference ÷ 100) × Remaining Balance × (Months Remaining ÷ 12)
(0.5% ÷ 100) × $300,000 × (36 ÷ 12) = $4,500
In this example, 0.5% multiplied by your remaining principal is $1,500. We then multiply that amount by 36 months, which gives us $54,000. Finally, we divide that amount by 12 months to get a final answer of $4,500.
Since the IRD is higher than the value of three months’ interest, the penalty for breaking your mortgage contract would be $4,500.
Although the notion of paying a penalty is as daunting as it is expensive, you may still be wondering how to get out of a mortgage without a penalty. Here are three possible solutions.
Porting your current mortgage
You may have locked yourself into a longer term mortgage, but decide to shift homes before the mortgage term is up. If a new property is the reason you want to get out of your current mortgage; porting or transferring your mortgage might be a good option. Many lenders will provide you a window of time to sell your existing home and move your current mortgage amount, rate and existing terms towards the new home purchase. If the new home requires a larger mortgage, you can often negotiate a blend-and-extend mortgage.
Blending and extending
In some cases, your lender may allow you to extend your mortgage before your term expires. This early renewal option is called a blend-and-extend mortgage. It gets its name from the fact that the interest rate of your existing mortgage gets blended with that of the new one to form a consolidated rate. This might be an attractive option if your motivation for getting out of your current mortgage is to take advantage of a lower mortgage rate or as a part of porting an existing mortgage. Best of all, the blend-and-extend mortgage does not usually require you to pay a penalty, but there may be administrative fees involved.
Before you choose this option, it’s important to find out how your lender calculates your interest rate. When looking for a renewal option that aligns with your needs, you should take all associated costs and fees into account.
Negotiating with your lender
By thoroughly scanning the market for other mortgage products, you may find a mortgage from competing lenders with better rates. Take notes on what you find and consult your broker if necessary. They may know of some alternatives for you and can help you negotiate.
Once you’ve compiled enough information, schedule a meeting with the lender to share your findings. If you arrive at the meeting properly prepared and your account is in good standing, the lender may be willing to match a competitor’s rate. Like many businesses, client retention is key for lenders. They do not like to lose clients to their competition and may be open to negotiation as a result.
Opt for an open mortgage or shorter term
If you know that during the course of your mortgage, you may need to move or face uncertain financial stability, it might be worth considering an open mortgage product. An open mortgage is different than a closed mortgage, as it allows you to pay off the entire balance anytime during the term without incurring a penalty. Usually, you will pay a higher interest rate in exchange for this privilege, but it can avoid costly penalties if you need to get out of your mortgage mid-term. The other easier option, is to just take a shorter 1 or 2 year mortgage term.
Waiting it out
If the costs of breaking your mortgage contract early are too prohibitive, it may be best to stay the course until the term ends. The lender will advise you that your mortgage is up for renewal at least 21 days before the expiration of the term. When that happens, you can shop around for a better mortgage product with the help of your broker.
If another lender offers a mortgage product that is better tailored towards your needs, you are free to move your mortgage to that lender if you wish. Once again, there are no penalties associated with this option, but some administrative fees may apply.
In the end, it’s up to you to determine whether or not breaking your mortgage contract is worth it. If you have the means and are prepared to deal with the penalty and other associated costs, you can follow through with that plan. But if the costs are simply too much to bear, it might be better to wait until the term ends and either negotiate a better rate with your lender or switch to another one