How To Get Out of A Mortgage Without Penalty By Selling Your Home
It’s something that very few first-time homeowners think about: what happens with your mortgage when you’re moving from one home to another?
No matter how perfect your current home is, there will likely come a point when it’s time to move. Whether upgrading to a larger home, relocating to a different city, or downsizing to an apartment, most people will move a few times in their lives.
A mortgage is actually a complex contract. If you choose to move mid-term, that contract may need to be restructured or broken. Doing so can incur a substantial financial penalty. However, with planning and knowledge, there are ways to get out of a mortgage without paying a fee.
What is a Prepayment Penalty?
Prepayment penalties exist because lenders lose money if you pay out a loan early. Lenders count on borrowers to take the full term to pay back loans–so that they can collect every interest payment. If you pay out your mortgage, a fee will help lenders recoup that lost interest.
Prepayment penalties aren’t always explained by the lender or broker when a mortgage is negotiated. However, information about prepayment penalties is included in any mortgage contract. That said, those documents are rich in legalese. Not everyone will bother to read the entire document; and some who do will struggle to understand what they’re reading.
How Much Will my Prepayment Penalty Be?
It can be complex to figure out the sum total of a prepayment penalty. This is especially true because there is no standard formula that all lenders follow. That said, lenders typically consider these factors in their calculations:
- Is the mortgage variable rate or fixed?
- How much is still owing?
- Have interest rates fallen or increased since you took out your mortgage?
- Did you receive any discounts or cash-back rewards when you signed the mortgage papers?
Of all of these, the most important factor is whether the mortgage is variable rate or fixed.
The Prepayment Penalty on a Variable Rate Mortgage
There is no prepayment penalty if you have an open, or variable rate, mortgage. Open mortgages can be paid off at any time, without penalty.
It goes without saying that this flexibility is a huge perk. However, there are drawbacks to these types of mortgages including:
- An opening interest rate which is typically higher than that of closed mortgages.
- A fluctuating interest rate, which is adjusted in tandem with market trends. While you might luck out and see your interest rate lowered at times, it could also increase.
You should always carefully consider all factors when choosing a mortgage. Still, if you’re looking into how to get out of a mortgage without penalty by selling your home, the absolute easiest way is to choose an open variable rate mortgage.
Calculating the Prepayment Penalty on a Fixed Rate Mortgage
With a closed or fixed rate mortgage:
- The interest rate doesn’t change during the term;
- The interest rate is typically lower than the opening rate for a variable rate mortgage; and
- You’re allowed to make limited prepayments–in most cases, up to 20% of your original mortgage balance on an annual basis.
The major drawback is that a prepayment penalty is normally charged if you break a fixed rate mortgage. It can be difficult for determine what exactly that prepayment penalty might be. As Ellen Roseman explains in a piece in the Toronto Star, it might be calculated in one of two ways.
First, if interest rates climbed since you signed on the dotted line, you will probably be charged the equivalent of three months’ of interest. The lender isn’t too concerned about losing your interest payments, since they can sign up another borrower at the new, higher interest rate.
But, if interest rates dropped since you signed your mortgage papers, your prepayment penalty may be calculated differently and it may be much higher. Any new borrower will receive a lower interest rate than your current one and your lender will lose money. The lender will want to make up for that loss.
If the interest rates dropped, a lender will look at both:
- The total sum of three months’ worth of interest; and
- the interest rate differential (IRD) between the rate when you signed your mortgage papers and the current rate.*
Typically, your prepayment penalty will be the higher of the two calculations.
*Your IRD can be calculated manually, using the formula provided on David Watts’ website. Or you can search for and use an online IRD calculator.
How to Decrease the Prepayment Penalty When Selling Your Home
If you’re not able to avoid paying the prepayment penalty altogether, it’s still worthwhile to see if you can get the penalty lowered.
Review Your Mortgage Contract Before Signing
Carefully and thoroughly read your mortgage papers before signing. Specifically look for details about prepayment penalties. Ask questions about discounts offered now, that may affect your IRD calculation later. Knowledge is key to decreasing or evading future prepayment penalties. If you struggle to understand the legalese, seek help from a lawyer or a mortgage broker.
Use Prepayment Clauses to Decrease Your Outstanding Principal
Does your fixed rate mortgage allow you to pay down your principal by a set amount annually? If so, decreasing your amount owing will also decrease the prepayment penalty.
How to Avoid Paying the Prepayment Penalty When Selling Your Home
Even though lenders are keen to recoup any losses they will incur if you break your mortgage, there are ways to get out of paying the prepayment penalty.
Opt for a Variable Rate Mortgage and/or Shorter Term
Since you can pay off your variable rate mortgage at any time, there are no prepayment penalties attached to these types of mortgages.
A shorter term can make it easier to wait until your mortgage is up for renewal before you sell your property. If you’re dealing with personal issues like illness or job loss, it may be easier to hang in there for a few months on a short-term mortgage than for a few years on a 5-year term.
Keep in mind that both variable rate mortgages and those with shorter terms will likely have higher interest rates.
Port Your Mortgage
If you will be buying a different property, ask your lender if you can transfer your existing mortgage to the new property. (This is called “porting.”) Not all lenders will allow this. But if
yours does, it’s one way of how to avoid paying the prepayment penalty when selling your home.
Ask if the New Buyer Can Assume Your Mortgage
Most banks won’t allow this, but it’s worth asking about. Since the person buying your house will likely need to take out a mortgage to pay for it, see if your lender will allow you to transfer your existing mortgage to the new buyer.
Look into a Blend-and-Extend Mortgage
The shoptherate.ca blog explains blend-and extend mortgages this way:
In some cases, your lender may allow you to extend your mortgage before your term expires. This early renewal option is called a blend-and-extend mortgage. It gets its name from the fact that the interest rate of your existing mortgage gets blended with that of the new one to form a consolidated rate.
The prepayment penalty is usually waived if your lender approves a blend-and-extend mortgage. However, you may need to pay other administrative fees.
Negotiate with Your Lender
When your mortgage term is coming up, start researching other lenders. Ask about their prepayment clauses and penalties. Then, ask for an appointment with your usual lender to go over the information you’ve gathered. As a piece at shoptherate.ca points out, “If you arrive at the meeting properly prepared and your account is in good standing, the lender may be willing to match a competitor’s rate. Like many businesses, client retention is key for lenders. They do not like to lose clients to their competition and may be open to negotiation as a result.”
Wait for Your Term to End
When your mortgage is up for renewal, you can switch products or lenders without penalty. If it’s possible to wait, this is one of the easiest ways to get out of a mortgage without paying fees.
If you’ve never had a mortgage before, you might be surprised about prepayment penalties. There may indeed be significant financial penalties to breaking your mortgage in order to move. However, by becoming familiar with your mortgage contract, asking questions, and making informed decisions, you may be able to avoid paying those fees.