Reducing Your Balance Before Breaking: A Strategy to Minimize the Penalty
When a Quebec borrower considers breaking their mortgage before term, the prepayment penalty is often the most significant cost involved. Few homeowners realize that it is possible to substantially reduce this penalty by using the prepayment privileges built into their mortgage contract before initiating the break. This strategy relies on a simple principle: the penalty is calculated on the remaining balance, so a lower balance means a lower penalty.
Understanding Prepayment Privileges
Nearly all mortgage contracts in Canada include prepayment clauses that allow the borrower to make a lump-sum payment each year without penalty. This privilege typically ranges between 10% and 20% of the original loan amount. For example, on a $400,000 mortgage, a 15% privilege allows a prepayment of $60,000 per year. Some lenders also offer the option to double regular payments or increase the monthly payment by a given percentage. These options are distinct from full repayment, which triggers the penalty.
- Prepayment Privilege
- A contractual clause in a mortgage agreement that allows the borrower to repay a portion of the principal (typically 10% to 20% of the original amount per year) without incurring a penalty. This privilege is separate from full loan repayment, which constitutes a contract break and triggers a penalty.
How Reducing the Balance Affects the Penalty
The prepayment penalty for a fixed-rate mortgage is the greater of two amounts: three months' interest or the interest rate differential (IRD). In both cases, the calculation is based on the mortgage balance at the time of the break. By reducing this balance through permitted prepayments, the borrower directly lowers the base on which the penalty is calculated. Consider a concrete example: a borrower with a $350,000 balance at a fixed rate of 5.25%, with 30 months remaining on the term and an IRD of 1.50%, would face an IRD penalty of approximately $13,125. If they make a $50,000 prepayment before the break, the balance drops to $300,000 and the IRD penalty decreases to approximately $11,250, a savings of $1,875.
Steps to Apply This Strategy Effectively
- Check your contractual privileges: Review your mortgage agreement for the maximum prepayment amount allowed, eligible dates, and conditions (notice period, minimum amount). If you have already used part of your privilege this year, calculate the remaining available amount.
- Obtain a penalty statement from your lender: Ask your current lender for an official penalty statement before and after the planned prepayment. This will allow you to quantify the exact savings. The statement will indicate the calculation method used (three months' interest or IRD).
- Evaluate the source of funds: Déterminé where the prepayment funds will come from: personal savings, TFSA, tax refund, or line of credit. If you are borrowing to make the payment, calculate the net cost accounting for interest paid on the temporary loan.
- Plan the timeline with your broker: Work with your AMF-certified mortgage broker to coordinate the timing of the prepayment and the contract break. The broker will ensure contractual deadlines are met and the entire operation is optimized.
- Make the prepayment then proceed with the break: Make the maximum prepayment, wait for confirmation from the lender that the balance has been adjusted, then initiate the break process. The notary in Quebec will handle the discharge of the existing mortgage and the registration of the new mortgage if you are transferring to another lender.