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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)

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)

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