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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.

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

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.  Review your mortgage disclosure/ documentation to understand the terms and conditions that relate to your mortgage.