How Are Prepayment Penalties Calculated?

How Are Prepayment Penalties Calculated?

Prepayment Penalties are meant to indemnify the lender for a borrower ending the term before the maturity date.

A prepayment penalty are typically either:
a) 3 month interest, or
b) The greater of:

3 months interest and
the Interest Rate Differential (IRD).

There are other types of prepayment penalties, such as a certain percentage of the amount being prepaid, but 3 months interest and IRD are the most common. See your loan agreement to determine the penalty provisions of your mortgage.

Example

Prepayment Amount:                         $500,000 (A)
Interest Rate:                                      4.00% (or 0.04 as a decimal) (B)
Remaining Term:     2 years and 2 months (or 26 months) (C)
Current Rate for Remaining Term: 3.00% (or 0.03 as a decimal) (D)

How to Estimate the Three Months’ Interest

Step 1: _$500,000__ (A)

How much do you want to prepay that is not allowed under your prepayment privileges?

Step 2: __4% (or .04) _ (B)

Your current annual interest rate

Step 3: ___$20,000__ (E)

A x B = E (this an estimate of the interest for 1 years)

Step 4: __$5,000__ (F)

E ÷ 4 = F (this is an estimated three months' interest)

How to Estimate the Interest Rate Differential

Step 1: __4% (or .04) (B)

Your current annual interest rate

Step 2: _3% (or 0.03) (D)

The published interest rate for a fixed interest rate mortgage closest to the remaining term of your mortgage.

Step 3: __1% (or 0.01) (G)

B - E = F, the difference between your current rate and the rate in B

Step 4: _$500,000____ (A)

How much do you want to prepay?

Step 5: ___26 months ___ (C)

The number of months remaining on your current term

Step 6: ___$10,833.33__ (F)

Prepayment Amount (A)   =                           $500,000
            x Interest Rate Differential   (G)          x   0.01
            x Number of months (C)                     x   26
            ÷ 12                                                     / 12

F = the estimated IRD

Additional Fees

When you make a prepayment, you may have other fees charged in addition to the prepayment penalty.

A Mortgage Discharge Fee will be applied for preparing the discharge statement.

A Mortgage Assignment Fee will be applied if you choose to assign your mortgage to another financial institution.

Always consult your mortgage disclosure and/or your mortgage professional when deciding what product is right for you. The IRD calculation may not apply to your mortgage. CReview your mortgage disclosure/ documentation to understand the terms and conditions that relate to your mortgage.