Prepayment Penalty
Pénalité de remboursement anticipé in French
Quick definition
A prepayment penalty is the fee a lender charges for breaking a closed mortgage before the end of its term. For closed variable rates it is typically three months' interest; for closed fixed rates it is the greater of three months' interest or the interest rate differential (IRD).
When the penalty applies
Most Canadian mortgages are closed, meaning you commit to the lender for the full mortgage term in exchange for a lower rate. Break that commitment before maturity, by selling the home, refinancing, or switching to another lender early, and the lender charges a prepayment penalty to compensate for the interest it expected to earn.
The penalty applies only to ending or overpaying the mortgage beyond what your contract allows. Regular payments, and prepayments within your annual privileges, never trigger it.
The standard formulas
For a closed variable-rate mortgage, the penalty is typically three months' interest on your outstanding balance, calculated at your current rate. It is simple and usually modest.
For a closed fixed-rate mortgage, the penalty is the greater of three months' interest or the interest rate differential (IRD). When rates have fallen since you signed, or when your lender uses an aggressive IRD formula, the IRD side wins, and it can be many times larger than three months' interest.
The IRD, and why big-bank penalties can be huge
The IRD is meant to cover the lender's lost interest. Conceptually, it is the difference between your rate and the rate the lender could charge today for a term matching your remaining time, applied to your balance for that remaining time. If you have 2 years left at 5.29% and the lender could only re-lend at 3.99% for 2 years, the IRD charges you roughly that 1.30% gap on your balance for 2 years.
The controversy is in which "today's rate" gets used. The big banks typically compute IRD from their posted rates, the inflated sticker rates almost nobody pays, minus the discount you originally received. Because posted rates sit well above real market rates, this formula widens the gap and can produce penalties of many thousands of dollars, sometimes $10,000 to $20,000 or more on a large balance.
Monoline lenders, the mortgage-only lenders that sell through brokers, generally compute IRD from the actual rates they charge new customers. Same concept, much smaller gap, much smaller penalty. Two borrowers with identical mortgages can face wildly different costs to break them, which makes the penalty formula worth checking before you sign, not after.
Open mortgages and prepayment privileges
An open mortgage can be prepaid or paid off at any time with no penalty. The catch is a noticeably higher rate, so open terms only make sense when you expect to end the mortgage soon, for example a pending sale or an inheritance on the way.
Closed mortgages are not sealed shut either. Most include prepayment privileges: typically the right to prepay 10% to 20% of the original principal each year as lump sums, plus the right to increase your regular payment, all penalty-free. The exact percentages and rules (calendar year vs. anniversary year, minimum amounts) vary by lender.
Ways to reduce or avoid the penalty
If a break is coming, a bit of planning can cut the cost meaningfully.
- Use your privileges first. Making your maximum penalty-free lump-sum prepayment just before breaking shrinks the balance the penalty is calculated on.
- Port the mortgage. If you are moving, many lenders let you transfer your existing rate and term to the new home, avoiding the penalty entirely.
- Blend and extend. Instead of breaking to grab a lower rate, your lender may blend your current rate with today's rate into a new, longer term with no cash penalty. Run the numbers; the penalty is usually baked into the blended rate.
- Ask for the exact quote. Lenders must disclose how the penalty is calculated, and most have online calculators. Quotes are only valid briefly since rates and balances move.
In Canada
Prepayment penalties are a fact of life in Canada because closed mortgages dominate the market. In the United States, prepayment penalties on residential mortgages were largely eliminated after the 2008 financial crisis, and borrowers routinely refinance whenever rates drop. Canadian borrowers face a real cost to do the same, which is why the choice between lenders, and between penalty formulas, matters more here.
Federally regulated lenders must disclose their prepayment penalty calculation and provide online calculators, a requirement that followed years of complaints about opaque IRD math.
Worked example: three months' interest vs. IRD
Dana has a $300,000 balance on a 5-year fixed mortgage at 5.29%, with 2 years left, and wants to break it (as an illustration, as of July 2026). Three months' interest is $300,000 x 5.29% x 3/12, about $3,970.
Her big bank calculates IRD from posted rates. When she signed, the posted 5-year rate was 6.79% and she received a 1.50% discount. Today's posted 2-year rate is 5.49%; subtracting her original discount gives a comparison rate of 3.99%. The IRD is $300,000 x (5.29% minus 3.99%) x 2 years, about $7,800. Her penalty is the greater of the two: $7,800.
A monoline lender with the same mortgage would compare against its actual 2-year rate, say 4.99%. The IRD becomes $300,000 x 0.30% x 2, about $1,800, so the penalty defaults to three months' interest: $3,970. Same mortgage, same rates paid, roughly half the exit cost.
Related terms
Reviewed by Alexandre Bernier, CFP®, CIM®, PFP®·Updated July 2026