Prepayment Penalties: The Real Numbers
When it comes to breaking your mortgage early, whether you're refinancing, selling your home, or making a life change—one word can hit hard: prepayment penalty.
It’s one of the most misunderstood parts of a mortgage, and as your mortgage broker, I’m here to give you the real talk and the real numbers behind prepayment penalties.
Let’s break it down so you know what you’re really signing up for.
What Is a Prepayment Penalty?
A prepayment penalty is a fee your lender charges if you pay off your mortgage before the end of your term. This could happen because:
You sell your home
You refinance to get a better rate
You switch lenders before your term is up
How much you’ll pay depends on who your lender is, your mortgage type, and how much time is left in your term.
📊 The Two Main Types of Prepayment Penalties
1. Three Months’ Interest
This is the easier one to calculate. If you have a variable-rate mortgage, this is typically the penalty.
Example:
Let’s say:
Your mortgage balance is $400,000
Your interest rate is 5.5%
Here’s the math:
5.5% annually = $22,000/year
Divide by 12 months = $1,833/month
Multiply by 3 = $5,500 penalty
✔️ Straightforward. But this is usually not what fixed-rate borrowers end up paying.
2. Interest Rate Differential (IRD)
This is the more complex (and often more expensive) penalty that applies to fixed-rate mortgages. It’s based on:
The difference between your contract rate and the lender’s current rate for a term matching your remaining time.
The time left on your mortgage.
Your mortgage balance.
Here’s a Realistic Scenario:
Let’s say:
Your mortgage balance is $400,000
You have 3 years left on a 5-year fixed term
Your rate is 5.5%
The lender’s current 3-year fixed rate is 3.5%
Rate difference = 2%
2% x $400,000 = $8,000/year
$8,000 x 3 years = $24,000
✅ Your prepayment penalty is $24,000.
Yup, this is why fixed-rate penalties can be a nasty surprise.
Why So Expensive?
Because the lender expected to earn a certain amount of interest over your full term. When you break the mortgage early, they lose out so the IRD is their way of recovering the shortfall.
Some major banks calculate IRD using the posted rate instead of their discounted rate - this inflates the penalty even more.
How to Avoid or Minimize Penalties
As your mortgage broker, part of my job is to structure your mortgage with flexibility in mind. Here are a few strategies:
Choose a variable-rate mortgage – Penalties are usually just 3 months’ interest.
Work with lenders with fairer IRD calculations – Not all lenders are equal. Ex. a mortgage finance company
Use prepayment privileges – Most lenders let you pay down 10–20% of your mortgage annually without penalty.
Time your move or refinance strategically – Breaking with less time left in your term usually means a smaller penalty.
We can approximately calculate penalties before you make a move – Knowledge is power. However rates change every day so checking with your existing lender may also be required.
Final Thoughts From Me
Prepayment penalties aren’t just fine print, they’re real dollars out of your pocket. And they can be massively different depending on your lender and mortgage type.
Before you lock into a mortgage, let’s talk about your long-term plans. If there’s even a chance you’ll need to break the term early, I’ll help you structure a mortgage that minimizes your risk and protects your wallet.