Breaking a fixed-rate mortgage before your agreed mortgage early term may prove costly in terms of the arm and leg. You may be one of those who want to refinance at low interest rates, sell your home, or switch to a variable-rate mortgage. Whatever your reason for breaking the mortgage contract early, understanding the nature of penalties apart from how they are calculated may prove quite crucial. An important thing to consider is carefully reading your mortgage agreement and speaking with your lender regarding the implications as well as options that can reduce your penalty.
The penalty on a fixed mortgage rate can vary considerably from one lender to another, and from one mortgage to another. Generally, most lenders have two methods for calculating penalties, namely, the Interest Rate Differential (IRD) and the three-month interest penalty. It determines the difference between the amount you currently pay on your mortgage and the current market rate multiplied by the remaining balance of your mortgage. Sometimes, this will result in a penalty bigger than your three-month interest penalty.
It is very important to consider your situation when making a decision; hence, it would be smart to make a careful examination of your financial well-being. Whether that saving will pay off the penalties you’ll incur from refinancing or switching the mortgage remains another consideration. For that kind of advice, seek the counsel of a mortgage broker or financial advisor. Knowing these options and costs ultimately helps you make the best choice about breaking your contract early. This means you’ll have the right to learn the important things that should be known about penalties and costs when breaking an early mortgage contract. Learn more on this blog.
What is the penalty for breaking fixed mortgage rate?
When you break a fixed-rate mortgage, you will typically incur a prepayment penalty or prepayment charge. Most mortgage principal lenders use either the Interest Rate Differential (IRD) or a flat three-month interest to calculate the penalty. The IRD calculation is standard with fixed-rate mortgages and compares your current fixed mortgage with the lender’s existing interest rate for an equivalent remaining term on the mortgage.
For example, if your existing mortgage contract currently carries an interest rate that is lower than the lender’s current offering, you will be charged a higher penalty, and this is because the lender would sustain a loss if it had to reinvest at a higher rate. Hence, the interest rate differential applies as well.
Interest Rate Differential (IRD)
The most common method through which mortgage penalties are determined is the interest rate differential. This is based on the difference between your fixed mortgage and the lender’s prevailing current interest rate for a mortgage of the same remaining term. The more substantial this difference, the larger your penalty will be. It is often that in those situations where significant months are remaining on the mortgage, the IRD is used.
With a fixed mortgage, the IRD generally determines how much you will pay extra if you want to break your mortgage early. Here’s how the mortgage penalty is calculated:
1. The lender compares your current mortgage interest rate with that of the lender’s promotional rate for the rest of your mortgage.
2. The penalty is then calculated based on the difference using the outstanding balance or the mortgage amount and the interest rates.
3. The greater the difference between the rates, the more you will pay with a penalty.
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Closed vs. Open Mortgage
In a closed mortgage, breaking your mortgage will incur heavy penalties. This is more so for the case of fixed-rate mortgages, which pay higher prepayment penalties. A closed mortgage is more restricted and does not allow you to pay off early without fees unless you are making an additional payment in the prepayment privilege given by the lender.
However, the open mortgage is more flexible, permitting you to make lump sum payments or fully pay off the entire mortgage before the maturity date with little or no penalty at all. Open mortgages however tend to have higher interest rates.
Prepayment penalties are charges made whenever you repay all or a part of your mortgage loan before the set date for maturity. Prepayment charges are mostly applicable to closed mortgages in most cases. The prepayment penalty may either be in the form of a month’s interest charge or calculated by the IRD. For variable rate mortgages, the design shall be much simpler, whereby the penalty usually is three months’ interest with no consideration of the rest term.
With fixed-rate mortgages, the prepayment penalties can be quite severe because the “entire mortgage balance,” “remaining term” and “rate discount you received at time of signing” all play into when figuring the amount of a penalty.
Variable Rate Mortgage
This mortgage offers a fluctuating interest rate that moves in line with the market. Unlike a fixed mortgage early, the monthly payments may change monthly depending on the lender’s prime rate. The advantage of a variable rate mortgage is that it will typically start with a lower interest rate than fixed mortgages, which might lead to easier carrying costs for you over the short run. The catch is that an interest rate increase will increase your mortgage payments, of course increasing your burden. Quite a lot of homeowners will take variable-rate mortgages when they are expecting interest rates to either stabilize or fall; the realness of that potential rise must, however, be prepared for.
Paying Off Your Mortgage Prematurely: Consequences
Breaking your mortgage contract early usually involves big penalties that may reduce the gain from refinancing or changing lenders. What could these penalties be?
Some of the most common factors are:
– Mortgage amount: The bigger the mortgage balance, the higher the penalty.
– Mortgage term: The more time remaining in the term, the greater the potential penalty.
– Amortization period: You are in a very early stage of the amortization of your mortgage; you tend to pay a heavier penalty.
– Interest rates: The difference between your fixed mortgage rate and the lender’s rate at the time of breaking is what determines how much you will have to pay for penalties.
On top of this, you will pay very heavy penalties if you are trying to break your mortgage and refinance to a lower interest rate or move to a new mortgage with a new lender.
Mortgage Contract and Penalty Fees
The mortgage contract will outline the early break mortgage penalties and conditions. Most lenders provide clauses permitting prepayment amounts up to a percentage value of the mortgage balance. Over this limit and/or if you attempt to exit the mortgage, the **paid fees can be expensive.”.
Make sure you read through your current mortgage contract quite closely also, because this is an area where it will pay to understand exactly how mortgage penalties are calculated so that you can do proper financial planning. Some mortgage providers offer prepayment privileges meaning you can pay a portion of the mortgage off each year without penalty, and doing so will essentially reduce your total interest over time.
Is It Worth Breaking a Fixed-Rate Mortgage?
Breaking a fixed-rate mortgage may be worthwhile if you are moving to a lower interest rate or to refinance and have cheaper monthly installments. The penalty fee, however, may negate the savings that you may get from breaking up the mortgage. When breaking a mortgage and switching to a variable-rate mortgage or a different lender, consider how much you save relative to the penalties you would incur.
In some cases, making extra payments within your lender’s prepayment privilege can retire the mortgage faster without penalties. When your mortgage term is almost complete, you may find it more beneficial to wait to make the mortgage payment at the mortgage maturity date with no penalty.
Things to Consider Before Breaking a Mortgage
Before breaking your mortgage, consider the following:
– The outstanding balance: The larger the outstanding balance, the more you’ll pay in penalty.
– The remaining term: As your maturity date approaches, penalties tend to decline.
– Rate differential: If your existing interest rate is significantly higher than rates are currently, you could realize that the penalty would be repaid in the long term.
– Monthly carrying costs: You want new mortgage conditions to sufficiently reduce your monthly payments to offset the penalty.
– Stress test effect: For taking over a new lender, you might be subjected to a mortgage stress test, that will lower the amount of available money to pay for your loan at a lower rate.
How to Reduce Penalties on a Fixed-Rate Mortgage
Some strategies can reduce penalties when you break a fixed mortgage rate :
Use prepayment privileges: Most lenders
let you make extra payments greater than your scheduled payment, but only up to a certain amount, without incurring a penalty. Use those extra payments to pay off your mortgage sooner.
Switch to an open mortgage: If you expect to apply extra payments or even pay it off early, an open mortgage may be the better choice for you.
– Wait till your maturity date: if you are near the end of your term, waiting till the mortgage maturity date can save you from having penalties at all.
– Check with the same lender: at times, staying with the same lender for your new mortgage can reduce or wipe out some penalties altogether.
Conclusion
You may have to pay penalties to exit a fixed mortgage rate, but there are a few instances where the financial benefits of switching to a low interest rate, or an alternative more suitable mortgage product will make the penalties worthwhile. Check your mortgage agreement, calculate the IRD penalty, and contact your lender to see what your circumstances might allow you to do. Always ensure that breaking your mortgage will save you money in the long term, taking into consideration the fees paid, associated penalties, and any possible changes in mortgage rates. Knowing how prepayment penalties, interest rate differential, and monthly payments factor into your mortgage, you can make an informed choice that makes a difference to your bottom line.
If you want expert advice on a mortgage customized specifically for you, all you need to do is talk to Shelto Mortgage. We can help and guide you in handling pre-payment penalties and getting you into the right mortgage products, hence making the right money-saving moves for you. Contact Shelto Mortgage today and let us do the rest to make your mortgage work for you!
