Here’s part 7 of my 10 step series on mortgages here at Financial Uproar every Wednesday.  Every step of the process will be covered from the application to qualifying to tips and tricks to save money on your mortgage and everything in between. To read all of these just click on the category Mortgage Basics.

So you’ve been following my advice on the other mortgage basics posts, and are ready to get yourself a great mortgage at a low rate. There’s just a few more things you have to worry about before signing on the bottom line. This week, let’s look at the ins and outs of payout penalties.

What Is A Payout Penalty?

A payout penalty is a fee the lending institution charges a borrower for breaking the mortgage early, typically because the borrower has sold their house. Since the lending institution bases your rate on their cost of borrowing (plus a healthy markup of course) they’ve committed to borrowing the same amount of money you are, just from different lenders at a different rate. So when a borrower repays their mortgage early, the lender gets this lump sum they have to lend out again, this time at a shorter term. Lenders build in a payout penalty in the mortgage to compensate them for such an event.

Borrowers typically have the right to pay down 20% of their remaining mortgage balance each year, without paying any penalty. Lenders do want to encourage people to pay their mortgage, they just don’t want people to do it too fast. Borrowers can also increase their payment 20% per year as well. These prepayment privileges are referred to as 20/20 prepayments in the industry.

Certain other lenders offer 15/15 prepayment privileges. Lenders who are offering rock bottom rates (especially 5 year fixed terms) are starting to offer no prepayment opportunities for the borrower, and will only break the mortgage contract on a sale. Since less than 10% of borrowers take advantage of their prepayment rights, this isn’t such a bad deal for most borrowers.

Now let’s look at the two types of payout penalties. Keep in mind that the mortgage company will charge the borrower whichever penalty ends up costing the borrower the most.

3 Months Interest

This payout penalty is very straightforward. On the date of the closing of the house sale (or the lump sum payment) the borrower owes 3 months worth of interest as a penalty. On the average mortgage in Canada, it works out to about $5000 or so, assuming you pay out the entire mortgage.

Since most mortgage payout penalties are incurred when people sell, typically people are paying a penalty on the entire mortgage. I was always amazed when I was in the industry how people didn’t even blink when they’d be told it would cost them thousands to break their mortgage early.

Interest Rate Differential

After mortgage rates came down aggressively during the crisis of 2008-09, many borrowers thought they’d go down to their bank and get themselves a new mortgage at the lower rates. What appeared to be a great idea on paper got quickly squashed once the borrower found out their payout penalty would be in the tens of thousands.

The interest rate differential (IRD) is somewhat complex to figure out, so let’s crack out our math. It’s essentially the amount owing, multiplied by the interest rate difference between the current rate and the rate on the mortgage, multiplied by the amount of time remaining. The IRD is only charged when rates have come down, because the lender wants a borrower to remain locked in at a higher rate.

Let’s look at an example. A borrower owes $300,000, 2 years in on a 5 year fixed mortgage at 5.89%. 5 year rates have fallen to 3.89%. How much would the payout penalty be?

$300,000 x 2% x 3 years = 6% of the mortgage balance = $18,000.

By the time somebody pays their real estate agent, that penalty can easily represent the entire profit from the sale of a house. Meanwhile, a borrower who is paying down their mortgage aggressively, will want to limit their yearly repayment at 19.9%.

Avoiding Prepayment Penalties

There are a couple strategies borrowers can implement to avoid paying these penalties.

The first strategy is to take out shorter terms on their mortgage, especially if they’re not certain they’ll be in one spot for the next 5 years. If a borrower takes out a year or 2 year term at a time, then they can attempt to time a sale to avoid a mortgage payout. Shorter terms are also generally cheaper than 5 year terms. Borrowers are always willing to pay for security.

Even if a borrower can’t quite time the sale with the expiry of their mortgage term, they can always get themselves a short term open mortgage, allowing themselves the right to payout the mortgage without a penalty, in exchange for a slightly higher rate.

The other strategy is to take out an open mortgage. These products did dry up during the crisis, however they’ve been making a comeback lately. The borrower can take out a 5 year variable mortgage, at prime, which allows a payout with only an administrative fee of a couple hundred bucks.

Stop Paying These Already

Canadians pay millions of dollars in payout penalties that can be avoided with a little planning. If a borrower isn’t certain they’ll be staying in a house for 5 years, then don’t go with the 5 year products (either fixed or variable). 1 or 2 year terms are cheaper than 5 year terms, plus they give the borrower a certain amount of flexibility when they want to sell.

Or, if a borrower knows they’ll be moving in 2 or 3 years,then maybe renting may be the way to go. House prices don’t always go up, combined with fees from Realtors and mortgage penalties could make owning a home a very expensive short term decision.

Tell everyone, yo!