Breaking a closed Canadian mortgage before the end of the term triggers a prepayment penalty. For variable-rate mortgages, the penalty is typically three months’ interest. For fixed-rate mortgages, it is the greater of three months’ interest or the Interest Rate Differential (IRD). The IRD calculation method varies by lender and can produce dramatically different penalty amounts. Always request the exact penalty in writing before deciding to break a mortgage.
Three months’ interest calculation
Three months’ interest = (Outstanding mortgage balance × Contract rate) / 4. A $400,000 balance at 4.75% has three months’ interest of $400,000 × 4.75% / 4 = $4,750. This penalty applies to most variable-rate mortgages and to fixed-rate mortgages when IRD is lower.
Interest Rate Differential (IRD)
IRD is the difference between the contract rate and the lender’s current rate for the remaining term, multiplied by the outstanding balance, multiplied by the remaining time. The basic formula:
IRD = (Contract rate – Comparison rate) × Outstanding balance × Years remaining in term
The comparison rate is typically the lender’s current posted rate for a term equal to the remaining term. A borrower at year 3 of a 5-year fixed term has 2 years remaining, so the comparison is the lender’s current 2-year fixed rate.
Posted rate vs discounted rate IRD
The IRD calculation method varies dramatically by lender:
| IRD method | How it works | Typical penalty for $400,000 balance |
|---|---|---|
| Discounted rate IRD (small banks, credit unions, monolines) | Difference between actual contract rate and current actual offer rate | $3,000 to $8,000 |
| Posted rate IRD (most major banks) | Difference between original posted rate and current posted rate (or specific posted rate as defined in contract) | $15,000 to $30,000+ |
Major banks use posted rates, which are typically 1% to 1.5% above actual offered rates. The IRD calculation using posted rates produces much larger penalties than discounted rate IRD. The mortgage contract specifies which method applies; review the prepayment clause carefully before signing.
Worked example: variable rate
$400,000 variable-rate mortgage at 5.20% (prime – 0.25%), 3 years into a 5-year term. Penalty: three months’ interest = $400,000 × 5.20% / 4 = $5,200.
Worked example: fixed rate, discounted IRD
$400,000 fixed-rate mortgage at 4.75%, 3 years into a 5-year term (2 years remaining). Lender’s current 2-year fixed actual offer rate: 4.20%.
- IRD: (4.75% – 4.20%) × $400,000 × 2 years = 0.55% × $400,000 × 2 = $4,400
- Three months’ interest: $400,000 × 4.75% / 4 = $4,750
- Penalty: greater of the two = $4,750 (three months’ interest wins)
Worked example: fixed rate, posted rate IRD
Same $400,000 mortgage at 4.75% contract rate, 2 years remaining. The lender’s original 5-year posted rate when the mortgage was set up: 5.95%. Lender’s current 2-year posted rate: 5.20%.
- The IRD comparison uses the difference between original posted rate (5.95%) minus a 1.20% discount = 4.75% (this is the contract rate). So no IRD?
- Some lenders use a different reference: original actual rate (4.75%) minus current 2-year actual rate (4.20%) for the IRD: as discounted IRD above
- Other major banks use posted-rate IRD: original 5-year posted (5.95%) minus current 2-year posted (5.20%) × $400,000 × 2 = 0.75% × $400,000 × 2 = $6,000
- Some banks add penalty interest “for losses suffered” formulas that produce penalties of $20,000+
The exact calculation can only be obtained from the specific lender. Always request the penalty quote in writing before paying it.
When prepayment penalties are waived
| Scenario | Penalty |
|---|---|
| Annual prepayment privilege (typically 10% to 20% of original principal) | None |
| Selling and “porting” the mortgage to a new property at the same lender | Typically none if completed in 30 to 90 days |
| Renewing at maturity at the same lender | None |
| Bona fide sale (selling property and not refinancing) | Some lenders waive; most do not |
| Death of borrower | Typically waived for surviving spouse |
| Marriage breakdown / divorce | Sometimes waived; check specific contract |
When breaking a mortgage makes sense
The decision to break and refinance depends on whether interest savings over the remaining term exceed the penalty. A general rule of thumb: if the new rate is at least 1.0 percentage point lower than the contract rate AND there are at least 2 years remaining in the term, breaking may be worthwhile. Use a refinance break-even calculator to verify with actual numbers.
Frequently asked questions
- What is the prepayment penalty on a variable-rate mortgage?
- Three months' interest, calculated as (balance × contract rate) / 4. A $400,000 balance at 5.20% has a $5,200 penalty.
- What is IRD?
- Interest Rate Differential. (Contract rate − Comparison rate) × Balance × Years remaining. The comparison rate method varies by lender.
- Why are major bank IRD penalties higher?
- Major banks calculate IRD using posted rates, which are typically 1% to 1.5% above actual offer rates. This inflates the penalty by 3x to 5x compared to discounted-rate IRD used by credit unions and monolines.
- Can I avoid penalties at renewal?
- Yes. Renewing at the same lender at the natural maturity date triggers no penalty. Switching lenders mid-term triggers the full penalty.
- Does porting a mortgage avoid the penalty?
- Usually yes if you sell and buy a new property within 30 to 90 days at the same lender. The mortgage is transferred to the new property.
- When does breaking a mortgage make financial sense?
- Generally when the new rate is at least 1.0 percentage point lower AND at least 2 years remain in the term. Use a refinance break-even calculator with actual penalty quote and new rate.
- Can I prepay without penalty?
- Most mortgages allow 10% to 20% annual prepayment of original principal without penalty. Lump-sum payments above the privilege amount trigger a partial penalty.