📖 Prepayment penalties: 3 months' interest vs IRD

First, the good news: what you can prepay for free

Almost every Canadian closed mortgage lets you prepay some of the balance each year without penalty, under terms set in your contract. The most common structures in the market are a lump-sum privilege of 15% or 20% of the original balance per year, plus the right to increase your regular payment by 15% or 20% once a year — but the percentages, the timing windows, and whether unused room carries over are entirely lender- and product-specific. (A discount no-frills mortgage may allow far less in exchange for its lower rate.) Everything in this guide about penalties applies only to money beyond those privileges, and the only source that counts for your mortgage is your own contract — check it before you prepay a dollar. Used well, the free privileges alone are powerful: the prepayment calculator shows what maxing them does to your interest bill and mortgage-free date.

Penalty type 1: three months' interest

Variable-rate mortgages (and the amount by which you exceed a fixed mortgage's privileges, at some lenders) are typically charged three months' interest on the amount prepaid or discharged. The formula is simple: balance × rate × 3/12. On a $400,000 balance at 4.49%, that is $400,000 × 4.49% × 0.25 = $4,490. Painful, predictable, and roughly proportional to your balance — which is why variable-rate borrowers can treat the penalty as a known cost of flexibility.

Penalty type 2: the interest rate differential (IRD)

Fixed-rate mortgages at most major lenders are charged the greater of three months' interest or the interest rate differential: roughly, the difference between your contract rate and the lender's current rate for a term matching your time remaining, multiplied by your balance and the years left. Simplified example: $400,000 at 4.49% with 3 years remaining, when the lender's comparable 3-year rate is 3.49%. The gap is 1.00%, so the estimate is 1% × $400,000 × 3 years = $12,000 — nearly three times the three-months figure on the same mortgage. Treat that as an illustration, not a quote: real IRD calculations at the big banks often start from posted rates rather than the discounted rate you actually received, which can make the differential — and the penalty — considerably larger than the simplified math suggests, and discount lenders calculate it differently again. Every figure in this section is an estimate; the only penalty that exists is the one your lender confirms in writing for a specific payout date.

Finding your real number before you act

Everything above is estimation, and lenders know estimates are how borrowers talk themselves into five-figure surprises. The actual process of getting your number is unglamorous and specific. Call your lender and ask for a payout statement (or a penalty quote) as of a specific date: it states the balance, the penalty calculated to that date, and the per-diem interest after it. Ask which method produced the penalty — three months' interest or IRD — and if it is IRD, ask which comparison rate was used; the answer tells you whether a broker's alternative lender (several calculate IRD against discounted rates rather than posted ones) would treat the same mortgage more kindly at renewal. Expect smaller charges on top: a discharge or transfer fee of a few hundred dollars (an estimate that varies by lender and province) is standard, and legal fees apply if the switch is structured as a refinance. Get the quote in writing and date it — penalties move with the bond market, and a verbal estimate from March is not evidence in June. Finally, note the asymmetry the whole system rests on: penalties are largest exactly when rates have fallen and breaking looks most attractive, because the IRD grows with the gap between your contract rate and today's rates. That is not a trick; it is the lender recovering the interest it priced your term on. But it means the break-even test below — not the rate headlines — is the only honest way to decide.

When breaking can still win: the break-even test

A penalty is a cost, not a verdict. The question is whether the savings from a new mortgage outrun it before the term would have ended anyway. The test: break-even months = penalty ÷ monthly savings. Use this site's verified refinance example — breaking a $400,000 mortgage from 5.5% to 4% saves $633 a month (run it yourself in the refinance calculator). Against a $4,490 three-months-interest penalty, break-even is about 7 months: break with more than 7 months of term left at that saving and the move pays. Against a $12,000 IRD penalty, break-even is about 19 months — the same refinance, a completely different answer. This is why "should I break my mortgage?" has no generic answer: it is your penalty type, your remaining term, and your rate gap, multiplied together. Three habits protect you. Get the penalty quoted in writing, dated, before you commit to anything. Ask whether porting your mortgage to a new property (often penalty-free) fits your actual plans better than breaking. And remember the calendar: at renewal, the penalty is zero — a move that fails the break-even test today may be free in fourteen months, which is exactly what the renewal guide is for.