Mortgage prepayment penalties in Canada: three months' interest vs the IRD

If you break a closed mortgage before the term ends, Canadian lenders usually charge a prepayment penalty. On most variable-rate mortgages it is three months' interest. On most fixed-rate mortgages it is the greater of three months' interest and the interest rate differential (IRD), which compensates the lender for the interest it loses if it can only re-lend your money at a lower rate. The IRD depends heavily on the comparison rate your lender uses, and lenders that compare against discounted posted rates can charge several times more than those that compare against their actual current rates. Always get a written penalty quote for your payout date before deciding.

This guide is part of the mortgage renewal checklist. Figures are illustrative.

When a penalty applies and when it does not

Situation	Penalty?
Paying out or switching on the maturity date	No
Renewing early within the lender's penalty-free window	No, if the lender offers one
Prepaying within your annual privileges (for example 15% lump sum)	No
Breaking to switch lenders before maturity	Yes
Selling the home without porting the mortgage	Yes, unless the lender waives it
Refinancing with the same lender during the term	Usually yes, sometimes reduced
Term longer than 5 years, after the fifth anniversary	Capped at three months' interest under the Interest Act
Open mortgage	No

Three months' interest

Formula: balance x annual rate x 3 / 12.

Illustrative: $350,000 at 3.89% = $350,000 x 0.0389 / 4 = $3,403.75.

This is easy to estimate with the three-month interest penalty estimator: enter the balance and your rate divided by four (0.9725 here), plus any discharge fee.

The interest rate differential

The basic idea: IRD = (your contract rate - comparison rate) x balance x time left in years. Lenders may also discount the result to a present value, which lowers it slightly. The key question is which comparison rate the lender uses.

Method A: posted rate minus your original discount

Many large banks start from their posted rate for a term close to the time remaining, then subtract the discount you received when you signed.

Illustrative mortgage:

Contract rate: 3.89%, which was the posted five-year rate of 5.94% minus a discount of 2.05 points
Time left: 30 months (2.5 years)
Balance: $350,000
Today's posted three-year rate: 5.49%

Comparison rate = 5.49% - 2.05% = 3.44%. IRD = (3.89% - 3.44%) x $350,000 x 2.5 = 0.45% x $350,000 x 2.5 = $3,937.50.

The penalty is the greater of $3,937.50 and $3,403.75, so $3,937.50.

Method B: the lender's current rate for the remaining term

Some lenders, often monoline lenders, use the rate they actually offer today for a term close to your time left. If that rate is 3.84%:

IRD = (3.89% - 3.84%) x $350,000 x 2.5 = $437.50, below three months' interest, so the penalty is $3,403.75.

How the IRD grows when rates fall

Using Method A, if today's posted three-year rate falls to 4.79%, the comparison rate becomes 4.79% - 2.05% = 2.74%:

IRD = (3.89% - 2.74%) x $350,000 x 2.5 = 1.15% x $350,000 x 2.5 = $10,062.50.

This is why a large original discount combined with falling rates can produce a penalty nearly three times the three-month figure.

Other amounts that can be added

Cash-back clawback: if you received cash-back, you may need to repay part of it.
Discharge or administration fee, set out in the lender's fee schedule.
Reinvestment or processing fees, depending on the lender.

Does breaking early ever pay?

Compare the penalty with the interest saved by moving to a lower rate for the rest of the term.

Illustrative: in the first scenario, breaking 3.89% to take 3.84% elsewhere would save only about 0.05% x $350,000 x 2.5 = $437.50 of interest, against a penalty of at least $3,403.75. It does not pay. Breaking usually pays only when the rate drop is large and the penalty is three months' interest, or when you need to break for other reasons, such as a sale. A blend-and-extend with your own lender can sometimes give part of the benefit without a penalty; see early renewal and blend-and-extend.

How to get an accurate number

Ask your lender for a written prepayment penalty quote for a specific payout date.
Ask which method it uses and which comparison rate and discount apply.
Check your mortgage agreement and the lender's prepayment information, which federally regulated lenders must make available.
Use your annual prepayment privilege first if allowed: some lenders calculate the penalty on the balance after the penalty-free amount.
Ask whether porting the mortgage to a new home avoids the penalty.

If you are comparing a break-and-switch with waiting until maturity, the full cost comparison is in the renew or switch worked example.

Frequently asked questions

Is the IRD legal?

Yes. Lenders can charge prepayment penalties set out in the mortgage contract. Federal rules require federally regulated lenders to disclose how penalties are calculated. The Interest Act limits the penalty to three months' interest after five years on terms longer than five years, for individual borrowers.

Can I avoid the penalty if I sell my home?

Possibly, by porting the mortgage to your new home if your lender allows it and you qualify. Some lenders also reduce penalties if you take a new mortgage with them.

Why is my penalty different from the calculator?

The estimator gives three months' interest only. Your lender may use the IRD, a present-value discount, a different balance date or add fees.

Are variable penalties always three months' interest?

Most are, but check your contract. Some lenders' variable mortgages have different terms.

Sources

Financial Consumer Agency of Canada — prepayment penalties and how to ask for a quote
Justice Laws Website — the Interest Act, section 10, and the Bank Act cost of borrowing rules
Office of the Superintendent of Financial Institutions — federally regulated lenders