How is a mortgage prepayment penalty calculated?
Fixed-rate mortgages are almost always charged the greater of two figures: a flat charge of about three months' interest at your current rate, or the interest rate differential (IRD). The IRD is what the lender loses by re-lending your balance at today's lower rate for the time left in your term — so it is the gap between your rate and the current rate, applied to your balance, for the remaining months. Variable-rate mortgages are usually capped at the flat three-month charge only. This calculator shows both figures side by side so you can see which one applies and why.
Why is my penalty so much bigger than three months' interest?
Because the interest rate differential took over. If rates have fallen since you signed, the lender loses income by letting you out early, and the IRD compensates them for that loss across your entire remaining term. The longer you have left and the wider the rate gap, the larger it gets — on a large balance with several years remaining it can run into five figures, many times the flat charge. This is why breaking a fixed mortgage early in its term, after rates have dropped, is the most expensive scenario.
Which rate does the lender compare against?
This is the single biggest variable and it is worth checking carefully. Some lenders compare your rate against their current posted rate for the remaining term; others use the discounted rate they would actually offer a new customer. Posted rates are higher, which widens the gap and inflates the IRD — sometimes several times over. Your mortgage contract states the method. Because of this variation, treat any online estimate, including this one, as an approximation and request the exact figure in writing.
Can I avoid the penalty entirely?
Sometimes. Many mortgages are portable, letting you move the existing rate and term to a new property without triggering a penalty. Others allow a penalty-free break at renewal, or if you are selling to an arm's-length buyer. Most also permit annual penalty-free prepayments (commonly 10 to 20 percent of the original balance) — making that maximum prepayment immediately before breaking reduces the balance the penalty is calculated on. Ask your lender which of these your contract allows.
Is paying the penalty ever worth it?
It can be, if the interest saved from a lower rate exceeds the penalty plus any legal, appraisal and discharge fees. Work out the penalty here, then use the Refinance Calculator to find the break-even point on the new rate. As a rough guide, the bigger your remaining balance and the longer you plan to keep the mortgage, the more likely breaking is worthwhile. If you expect to sell within a couple of years, it rarely is.
Are there other fees besides the penalty?
Usually yes. Expect a discharge or administration fee, and if you are moving lenders there may be legal fees, an appraisal, and title insurance. Individually these are modest compared with an IRD penalty, but together they can add a meaningful amount — include them when working out whether breaking your mortgage pays off.