Prepayment Charge

A prepayment charge is another name for a prepayment penalty — the fee a lender may charge when a borrower repays more of a closed mortgage than the contract permits, or pays the mortgage out before the term ends. Canadian lenders use the two terms interchangeably: "penalty" appears most often in disclosure documents, while "charge" appears in many mortgage contracts and payout statements.

Because a closed mortgage locks in a rate for a set term, the lender expects a stream of interest. When that stream is cut short, the lender may lose the interest it priced into the loan. The prepayment charge is intended to offset part of that loss. Federal cost-of-borrowing disclosure rules require lenders to explain how the charge is calculated, so the method should be set out in the mortgage documents.

How the charge is calculated

Most closed mortgages let a borrower prepay a percentage of the original principal each year without charge. Amounts beyond that limit, and full payouts before maturity, can trigger the fee. The two common methods are:

• Three months' interest — commonly applied to variable-rate mortgages and to some fixed-rate products.
• Interest rate differential (IRD) — commonly applied to fixed-rate closed mortgages, comparing the lender's rate on the existing mortgage with the rate currently available for a term similar to the remaining term.

Many lenders charge the greater of the two. IRD math differs from one lender to the next, and whether the comparison uses the posted rate or the discounted rate can change the result substantially, so the same balance can produce very different charges at different institutions.

Using privileges to avoid the charge

A prepayment privilege is the contractual allowance that lets a borrower pay extra without triggering a charge. Common forms include increased payments, lump-sum payments, and accelerated payment schedules. Staying within those limits, or waiting until the maturity date, avoids the fee entirely. When a borrower needs to move or refinance early, options such as blend and extend, portability, or a switch at renewal may reduce or eliminate the charge — but only if the specific contract allows them.

A short example

Suppose a borrower with a closed fixed-rate mortgage wants to pay it out mid-term. The lender calculates three months' interest and the IRD, then charges whichever is higher. If the same borrower instead waits until the term expires, the mortgage can be repaid or renewed with no prepayment charge. A mortgage penalty calculator can give a rough estimate, but only the lender's written payout statement shows the exact figure.