When you enter into a mortgage contract, you are committing to a long-term loan that can take decades to pay back. Homes cost a lot of money, after all, and the alternative is saving for even longer.
However, it is not uncommon for homeowners to realize that their mortgage contract is not working for them, and they need a change while still in the middle of their term or amortization period. Being stuck in a contract that isn't working can be uncomfortable at best and disastrous at worst.
Luckily, though your mortgage contract is legally binding, there is a way out provided by your lender. While this can be helpful for homeowners who need to get out of a mortgage contract, banks are not going simply allow you to break your mortgage contract without any penalty.
When you break your existing mortgage contract, there will often be a penalty, the severity of which will depend on a few factors. This penalty allows homeowners to exit their contracts while allowing banks to still collect the money they were planning on receiving.
Deciding to break your mortgage contract can be a huge decision and one that you should not take lightly. In this article, we will explain why you may choose to pursue this option and what sorts of penalties you can expect.
What does it mean to break your mortgage?
When you agree to a mortgage contract, you agree to continue to pay a certain amount over a set period of time - your amortization period - divided into smaller terms. The period of time is important, as it allows the bank to determine how much they can profit from lending to you.
When you break your mortgage, you end the contract early and are allowed to repay your mortgage or look for financing elsewhere. In order to make up for the lost profit, the bank will agree to end the contract as long as they are paid a fee determined by the value of your interest.
How early can you break your mortgage contract?
As a mortgage borrower, you will need to renew your current mortgage at the end of each term. When you do so, your current mortgage contract ends, and a new one takes its place. Lenders often offer a few months grace period to renew your contract early. This is not considered breaking a mortgagee contract and will not incur any penalties as a result.
Breaking your contract early occurs when you violate any of the terms of the loan outside of this renewal period or in a way that is not permitted. This can occur at any time in your mortgage.
Though there is no limit on when you can break your contract, if you do so intentionally, you should carefully consider the timing of this decision. The time frame in which you break your mortgage contract will significantly affect how much you end up paying in penalties, which we will explore later on.
Open vs. closed mortgages
It is important to note that the considerations about when to break your mortgage generally only apply to closed mortgages. In a closed mortgage, you agree to a fixed term and cannot pay back your mortgage early without penalty. In an open mortgage, you can pay back your mortgage as much as you want as soon as you want.
The difference between the two comes down to cost. When you end your mortgage early, the bank misses out on potentially years of interest payments. Open mortgages generally have much higher interest rates to make up for less certain profits.
For this reason, closed mortgages are the most popular option for a large majority of homeowners. Buyers will usually only enter into an open mortgage if they have realistic plans to pay back their mortgage early and are willing to cover the increased costs.
What happens when you break your mortgage contract early?
A few things can happen when you break your mortgage contract early.
The first would be a mortgage default due to a missed payment. Since you agreed to pay on time every month, missing a payment is a violation of your mortgage contract. In this case, it is usually an accident or an unavoidable circumstance for a homeowner who otherwise wants to continue their mortgage.
You will need to work with your bank to remedy the situation, including outcomes like a penalty fee and increased future payments to compensate for the missed value. Missing a mortgage payment is a horrible situation because it can damage your credit score or result in the loss of your home. If you suspect you may miss a mortgage payment, you should talk to your lender as soon as possible.
The other time homeowners may choose to end their mortgage early is by paying it off either with savings or through a refinance. In this case, you have broken the mortgage contract, but the fact that you have also paid it off makes it a lot more welcome by banks.
The bank has been paid back in full for what it borrowed, but they have also lost some potential revenue in the form of interest. In this case, your bank will usually charge you a penalty fee, the value of which will be based on your mortgage terms and interest rate. As long as you pay this penalty, there will be little consequences or damage to your personal financial health.
How are penalties calculated?
When you decide to break your mortgage early, there are a few ways your bank will choose to calculate your penalty. Generally, this calculation will be outlined somewhere in your initial mortgage agreement.
When it comes to breaking your mortgage, a fixed rate mortgage and a variable rate mortgage will have their penalties calculated differently. In many cases, the variable rate mortgage will be the cheaper of the two to break, though this will depend on current interest rates.
Breaking a variable rate mortgage
The simplest calculation is used for variable rate mortgages. If you break a variable rate mortgage early, your penalty will be equal to 3 months of interest at either your current rate or at the lender's prime rate, depending on the lender.
For example, if you had a variable rate mortgage at 4% interest with $200,000 remaining in your mortgage balance, your penalty would be calculated as follows:
- 200,000 × 4% × (3/12) = $2000
It would cost you $2000 to break this mortgage.
Breaking a fixed rate mortgage
With a fixed-rate mortgage, things get a bit more complicated. When you opt to break a fixed rate mortgage contract early, you will pay either three months of interest or the value of what is called the Interest Rate Differential (IRD), whichever is higher. For the three-month calculation, it will be essentially the same as above. The IRD, however, takes a bit more explanation.
An Interest Rate Differential represents the difference between the interest you would pay your lender calculated at two different rates. The first of these rates is the rate, excluding any discounts, that was active on the day you signed your mortgage. The second rate is the posted rate for the length of time closest to the amount of time left on your mortgage. So, for example, if you were two years into a five-year term (thus had three years left), your bank would calculate your IRD using your current rate and their three-year mortgage rate.
Once the bank has determined these two mortgage rates, they will find the difference between the two and use this rate to calculate a hypothetical interest amount for the remainder of your term.
Let's look at an example to help make this clear.
Like before, you have a remaining mortgage of $200,000 with 3 years left on the term. When you signed your mortgage, the most current posted rate for a fixed rate mortgage was 5.5%. Your bank's current posted three-year interest rate is currently 4.5%.
The difference between these two mortgage rates is equal to (0.055 - 0.045) or about 1%. This rate equals out to about 0.00083% per month. Multiplied over 36 months, you get 3%, then this is finally multiplied by your remaining principal to reach the final payment amount of about $6000.
If you instead calculated three months of interest at your current rate, you would get $2250, meaning you would pay the higher IRD penalty.
Note that these figures do not represent a real case but rather a hypothetical demonstrating how quickly your mortgage penalties can stack up. In addition, the IRD is a bit of a cumbersome figure to work out, and you may make a mathematical error along the way. When considering the penalties of breaking your mortgage, you should always speak to your lender or a mortgage broker who will be able to calculate the most accurate penalty for your circumstance. This will be crucial for determining the feasibility of breaking your contract.
Why would someone break their mortgage?
So now that you understand the potential costs of breaking your mortgage, you might be wondering why someone would go this route. If someone is willing to pay thousands of dollars to break their contract, the alternative must offer them even greater savings. Ideally, this is true, but it is also why you must carefully consider the outcomes before breaking your mortgage contract.
One common reason to break a mortgage contract is to refinance the mortgage. Beyond offering you the ability to change your mortgage contract on nearly every level, a refinance can allow you to draw a significant amount of your home's equity out. This large equity payment may very well make up for the penalty you will incur, though this will depend on the size of your penalty and the amount of equity available in your home. On the other hand, if the penalty is too great, you may want to consider using something like a HELOC to access equity without breaking your mortgage contract.
Looking for a better rate
You may also be choosing to leave your mortgage to get a better rate elsewhere. This will only make sense if the savings you make from switching are greater than the amount you will need to pay for a penalty. Once again, you should consult a professional who can run these numbers for you, as interest calculations can get complicated. In this case, you may also have the option of waiting until the end of your term to end your mortgage without penalty, which might be the more financially sound option overall.
Buying a new home
Another reason a homeowner may break their mortgage early is if they are moving to a new home either by choice or due to a change in personal circumstances. In this case, it may come in handy if you can port your mortgage to avoid penalties, though this may not be an option in all cases. If you really must sell your home, you will be forced to pay the fine, so you should try and be aware of how much you will need to pay to account for this in your search for a new home.
Options to avoid early prepayment penalties
Because of the hefty penalties that breaking your mortgage can incur, you might be interested in some strategies to reduce your penalties. Luckily, there are some ways you can reduce or eliminate your early prepayment penalty.
First of all, there is often an amount of your mortgage that you can pay back early without any penalties at all. If you know that you will break your mortgage contract in advance, it may be worth paying as much as possible in prepayment privileges to reduce the principal amount used to calculate your penalties. Be aware, however, that some lenders will limit your ability to use this option if you are too close to the date you break your mortgage.
Wait until the end of your term
You may also choose to wait until the end of your term to end your mortgage contract. At the end of your term, there will be no penalties for paying off your mortgage or renewing elsewhere. Depending on the fees your bank may charge you, and if you have time to wait, it may cost less to continue paying interest for the remainder of the term than it would to pay in full and incur a mortgage penalty.
Get a blended rate or port your mortgage
If you are breaking your mortgage contract to refinance elsewhere with a lower rate, you may also want to consider a blended mortgage rate. This can allow you to access a lower mortgage rate while still keeping your mortgage intact, thus avoiding penalties. If you are breaking your mortgage to buy a new home, you may be able to port your mortgage, which can help you avoid penalties.
Each option will present its upsides and downsides, and some, like early prepayments, may require you to plan some time in advance. Before you break your mortgage or employ one of these alternative strategies, we encourage you to speak with a mortgage professional who can speak more in-depth regarding your particular needs.
Mortgage contracts may seem concrete, but they aren't unbreakable. Your lender knows that circumstances change, and so long as the deal can remain financially beneficial, they are willing to work with lenders to break their contracts early.
The most important thing to know, however, is just how much you stand to pay in penalties before you make any decisions regarding breaking your mortgage, as this can significantly impact your plans moving forward.
If you want a change but aren't set on breaking your mortgage entirely, you can also consider some options that may help you make a change without breaking your mortgage.
Once again, we encourage any homeowner to consult with a mortgage professional for accurate information and advice on their personal circumstances before they make any decisions.