What No One Tells You About Prepayment Penalties (And How to Avoid Them)

Imagine you need to move unexpectedly — maybe for work, divorce, or a bigger home. If you break your mortgage early, you could face a penalty that wipes out your rate savings.

✅ What is a prepayment penalty?

It’s a fee that lenders impose when borrowers decide to pay off their mortgage before the specified term has concluded, a situation often referred to as prepayment. This fee is designed to compensate the lender for the potential loss of interest income that would have been earned had the borrower continued to make regular payments until the end of the mortgage term.

For fixed-rate mortgages, the calculation of this fee typically involves determining the greater of two amounts: three months’ worth of interest payments or what is known as the Interest Rate Differential (IRD).

The IRD is a more complex calculation that reflects the difference between the interest rate on the original mortgage and the current prevailing interest rates available in the market at the time of prepayment. The rationale behind this fee lies in the lender’s need to manage their financial risk and maintain profitability.

When a borrower pays off their mortgage early, the lender not only loses the expected interest payments that would have been received over the remaining term but also faces the challenge of reinvesting the returned principal at potentially lower interest rates. As a result, the IRD helps to quantify this loss by assessing how much income the lender is forfeiting due to the early repayment in comparison to current market conditions.

For borrowers considering paying off their mortgage early, it is crucial to understand both of these calculations, as they can significantly impact the overall cost of prepayment. The fee structure can vary between lenders and mortgage products, so it is advisable for borrowers to review their mortgage agreements carefully and consult with their lender to fully comprehend the implications of prepaying their loan.

Additionally, some lenders may offer options to make extra payments or pay down the principal without incurring these fees, which can provide borrowers with some flexibility in managing their mortgage payments while avoiding additional costs.

✅ How big can it be?

Example: On a $400,000 fixed-rate mortgage at 4.5% with 2 years left, if current rates are 3%, you might face a $12,000+ penalty.

✅ How to protect yourself

• Ask about penalties before you sign — Some lenders are more forgiving.

• Portability features — Let you transfer your mortgage to a new home without penalty.

• Consider shorter terms or open mortgages — You’ll pay more in rate, but gain flexibility.

💡 Tip: The lowest rate isn’t always the cheapest mortgage overall. A broker can help you weigh penalties and features.