Before You Sign: Where Your Mortgage Penalty Is Spelled Out, and What Your Lender Must Tell You

The mistake: comparing only the payment

Two mortgages can carry the same monthly payment and very different costs to leave. You usually find out which one you have only when you need to leave.

According to the Financial Consumer Agency of Canada (FCAC), a lender may charge a prepayment penalty if you pay more than your allowed extra amount, break the contract, move the mortgage to another lender before the term ends, or pay it off early, including when you sell. FCAC notes that these charges can run into the thousands of dollars. An open mortgage is the exception: it allows prepayment without a charge.

Life changes on its own schedule. A job move, a separation, a growing family or a better offer at another lender can all arrive mid-term. In the Ontario files we see, the penalty is often the single largest cost of making that change, and it was set the day the mortgage was signed.

What your lender is required to tell you

For federally regulated lenders, which includes the banks, the requirements are specific. FCAC's consumer page says the agreement must open with an information box that covers your prepayment privileges and penalties, among other key terms, and that the lender must explain how the penalty is calculated and what factors it uses, in language that is clear, simple and not misleading.

FCAC's Commissioner's Guidance CG-9 sets out what that means in practice. In summary, the lender should:

• State whether you have the right to repay before the term ends, and on what terms.
• Describe each component of the penalty formula, such as a posted figure or the discount you received, so you can understand it.
• Give you the values, tell you where to find them, or provide a toll-free number to staff who can.
• Where the formula is complex, include a simplified calculation that ignores the time value of money, marked as an estimate. The guidance says that estimate will come out higher than the actual charge.

The same guidance points to the Cost of Borrowing Regulations for renewals: if a mortgage is to renew on a set date, the lender must send a new disclosure statement at least 21 days before that date. That statement is your second chance to read the penalty terms before you are locked in again.

How the penalty is usually worked out

Formulas vary, but FCAC describes the common one: the higher of three months' interest on the balance, or the interest differential. The differential compares the interest left on your term at your contract figure with the interest at a comparison figure for the time remaining, and charges the difference. FCAC says lenders usually use the differential when your contract figure is above today's and the contract was signed less than five years ago.

The comparison figure is where lenders differ most. FCAC describes two approaches: some compare against the current posted figure for a similar term, others compare against that posted figure minus the discount you were originally given. When a borrower received a large discount off a posted figure, the second method can produce a much larger charge on the same balance.

FCAC's own illustration uses a $200,000 balance at 6%, with 36 months left, against a current posted 4% for a 36-month term. Three months' interest comes to about $3,000; the differential to about $12,000. The penalty is the higher figure, about $12,000, possibly plus an administration fee. That is FCAC's example, not a typical file, and your contract sets the real answer.

Variable mortgages are usually different: many charge three months' interest only. Why fixed penalties tend to be larger walks through the gap.

Five questions to ask before you sign

• Which comparison figure do you use for the differential? Posted, or posted minus my discount?
• What are my prepayment privileges each year, and do unused amounts carry forward? FCAC notes they usually do not.
• Can I port this mortgage to a new home, and on what conditions? Porting has limits worth knowing.
• Is there a blend-and-extend option if I need more money mid-term? Here is how that works.
• Is this a standard or collateral charge, and what does it cost to switch at renewal?

If the answers are not in writing, ask for them in writing. A lender that discloses clearly at the start is usually the one that is easiest to deal with at the end.

If you already have a penalty to think about

FCAC lists several ways to reduce or avoid the charge: use your annual prepayment privileges fully, since a lower balance means a lower penalty; wait until the term ends if the charge is large; port the mortgage when you buy another home; and shop around at renewal. It also warns that some lenders restrict prepayments close to the date you break the contract, so timing matters.

Before you break anything, get the lender's figure for a specific payout date, then weigh it against what you gain. Our Penalty Protector Pro page explains how lenders choose the comparison figure, and the Break or Stay tool on our calculators page runs the arithmetic both ways. If your term ends within a few months, renewal may simply be the cheaper door.