Breaking your mortgage early could cost you $15,000 — unless you know these 4 rules

But switching before your term is up is a different story. Breaking your mortgage mid-contract can come with a significant penalty — sometimes tens of thousands of dollars. Before you make any moves, here's what you need to know.

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Key factors to consider before switching your mortgage in Canada

Switching your mortgage isn't as easy as calling your broker and saying, "Hey, I think I'd like to try something new." There are a few important things to weigh first.

Understand your mortgage contract

A mortgage is a binding contract you signed at the beginning of your term. You're contractually obliged to keep up your regular payments, which are based on your mortgage size, amortization period, term length and interest rate. However, you can switch your mortgage if you've found another one that makes more sense for your situation.

Before doing that, read your current contract carefully. It will outline whether your mortgage is open or closed. If yours is open, you'll likely be able to break it without paying fees. If, however, your mortgage is like most Canadian mortgages, it's closed — and there will be fees associated with breaking your contract.

Assess interest rates

A better interest rate is the most common reason to switch mortgages. Do your research to see what's available, and speak to a broker to determine if you qualify for a lower rate. Use a mortgage calculator to understand how your monthly payments would change if you switched.

Once you factor in the penalties you can expect to pay for breaking your mortgage early, you'll be able to determine whether the switch is actually worth it.

Evaluate prepayment options and penalties

Before making the switch, consider the new mortgage's terms. If you'd like to make additional payments above your regular ones (prepayments that help you pay off your mortgage sooner), check what prepayment privileges the new mortgage offers. Typically, mortgages allow for a specific amount of prepayments per year.

Also, look carefully at penalties — not all mortgages are equally flexible. Depending on the lender, there might be penalties for late payments and for breaking your mortgage.

How much home can you afford?

Whether you're hunting for a new home or looking to refinance your mortgage, knowing how much your new loan might cost you is critical. Use our handy mortgage calculator to help you understand what your payments could look like.

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Consider the cost of breaking your mortgage

Before breaking your current mortgage, it's essential to understand whether it makes financial sense. Even if you qualify for a lower rate, any savings may be wiped out by the penalty for breaking your existing contract.

While your lender can help guide you through the process, it’s a good idea to understand how penalties whether you have a fixed- or variable-rate mortgage.

Fixed-rate mortgages: The interest rate differential

The penalty for breaking a fixed-rate mortgage is usually calculated using an interest rate differential (IRD). Each lender has its own way of calculating this, but generally, the lender estimates how much interest it will lose if it re-lends your remaining balance at current rates, compared to your contracted rate.

One critical difference to know: Big banks typically use inflated ‘posted rates’ in their IRD calculations, rather than the actual discounted rate you received — and it’s part of your mortgage contract. This can roughly double your penalty compared to a monoline lender or credit union, which uses actual market rates. On the same mortgage, a big bank might charge you $15,750 in IRD penalties versus a monoline lender's $7,875 — for the identical scenario (1).

Online prepayment calculators can help you estimate your penalty before approaching your lender.

Variable-rate mortgages: three months' interest

The penalty for breaking a variable-rate mortgage is much more straightforward. The lender will charge you three months' worth of interest on your current mortgage principal. At today's rates, that typically amounts to between $3,000 and $6,000 on a standard Canadian mortgage — considerably less than a fixed-rate IRD penalty.

When you know how much you can expect to pay in penalties, weigh that against the potential savings from the new mortgage. Also consider other potential costs, such as discharge fees — your lender will outline these, and a broker can help explain them.

What the math looks like when switching mortgage lenders

Getting a better interest rate is a great reason to switch lenders — but you need to crunch the numbers first. Let's use a hypothetical example.

Let's assume you have a 5-year fixed rate of 5.25% on a $400,000 mortgage, with three years left on your term. You've qualified for a new rate of 4.04% with a different lender. Your remaining principal is approximately $375,000. Your interest cost over the remaining three years is roughly $58,000. If you switch to the lower rate of 4.04%, that interest drops to roughly $45,000 — a savings of roughly $13,000.

However, you need to factor in the cost of breaking the mortgage. Using a prepayment calculator can help you estimate the IRD cost — but it’s always wise to call and ask your lender for the actual cost. Assuming your current mortgage is with a big bank, the IRD penalty could easily reach $15,000 or more — wiping out the entire interest savings and then some. At a monoline lender, the same penalty might be closer to $7,800, which could make the switch financially worthwhile.

This is why it's essential to know not just what the penalty is, but how your lender calculates it. Compare mortgage rates to see what's available, ask your lender for an exact penalty figure, then do the math — or have a broker walk you through it.