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Summary: A mortgage prepayment penalty is the fee a lender charges when you break a closed mortgage before its term ends. On a fixed-rate mortgage you usually pay the greater of three months' interest or the interest rate differential, which can run into the thousands.
What is a mortgage prepayment penalty?
A prepayment penalty is a charge your lender applies when you pay off, refinance, or break a closed mortgage before the end of its term. It compensates the lender for interest it expected to earn over the time remaining on your contract.
Most Canadians hold a closed mortgage, which locks in a rate for a set term (commonly one to five years) in exchange for a lower rate. Paying it off early triggers the penalty. An open mortgage lets you repay any amount at any time with no penalty, but it carries a higher rate.
Most closed mortgages also include prepayment privileges: the ability to pay down 10% to 20% of the original principal each year, or to increase your regular payment, without any charge. Using these first lowers the balance a penalty is later calculated on.
How is a prepayment penalty calculated?
Lenders calculate the penalty two ways and charge whichever is greater: three months' interest on your balance, or the interest rate differential (IRD). Variable-rate mortgages almost always use the simpler three-months'-interest method.
Three months' interest is straightforward. On a $500,000 balance at 4.5%, it works out to roughly $5,625 ($500,000 × 4.5% × 3 ÷ 12). The IRD is the lender's estimate of the interest it loses because rates have changed: it applies the gap between your contract rate and the rate it could charge today for a comparable remaining term across your balance and the months left. When rates have fallen since you signed a fixed mortgage, the IRD can be several times larger than three months' interest, sometimes $10,000 or more.
Variable-rate closed mortgage | Fixed-rate closed mortgage | |
Usual penalty | Three months' interest | Greater of three months' interest or the IRD |
Typical size | Predictable and smaller | Can be much larger when rates have dropped |
Main driver | Your current rate | Gap between your rate and today's rates |
Lenders vary in how they run the IRD math, so the same balance can produce different quotes. The Financial Consumer Agency of Canada (FCAC) requires federally regulated lenders to disclose how they calculate the charge. One statutory protection is worth knowing: under the Interest Act (Canada), a mortgage with a term longer than five years can be prepaid once five years have passed, with the penalty capped at three months' interest.
When do you pay a prepayment penalty?
You face a penalty whenever you settle a closed mortgage before its term is up. The most common triggers involve leaving your current mortgage behind rather than carrying it forward.
Refinancing mid-term. Breaking your mortgage to secure a lower rate or pull out equity before renewal.
Selling without porting. Selling your home and discharging the mortgage instead of moving it to your next property.
Switching lenders. Moving your balance to another bank or credit union partway through the term.
Paying off with a windfall. Clearing the full balance early with savings, an inheritance, or a bonus, beyond your annual privilege amount.
How can you reduce or avoid a prepayment penalty?
You can often shrink or sidestep the charge with a bit of planning. The right move depends on your mortgage type, how far you are into the term, and whether you are moving or simply chasing a lower rate.
Use your prepayment privileges first. Apply your annual 10% to 20% lump-sum room before breaking the mortgage, so any penalty is calculated on a smaller balance.
Port your mortgage. Many lenders let you carry your existing rate and term to a new property, avoiding the penalty entirely if the timing lines up.
Ask about a blend-and-extend. Your lender may blend your current rate with today's rate over a new term, folding in the cost instead of charging a lump-sum penalty.
Time the break near the end of your term. With only a few months left, the three-months'-interest figure is small and the IRD often disappears.
Choose a variable or open mortgage if you expect to move or refinance soon, since their penalties are smaller or nonexistent.
How does the penalty get paid when you sell or refinance?
When you sell or refinance, the penalty is paid from the transaction rather than out of pocket separately. Your real estate lawyer requests the lender's payout statement, pays the outstanding balance plus the penalty from the closing funds, and registers the discharge on title.
That payout statement itemizes the principal, the interest owing to the closing date, the prepayment charge, and any discharge or administrative fee. On a sale, your lawyer pays it from the sale proceeds through the firm's trust account; on a refinance, it comes out of the new mortgage advance. Seeing the figure early matters, because it changes how much equity you walk away with or how much you can borrow. It sits alongside your other costs involved in a real estate transaction, so it is worth requesting the exact quote from your lender before you commit to a sale or refinance date.
Frequently asked questions
Do all mortgages have a prepayment penalty?
No. Open mortgages let you repay any amount at any time without a charge. Closed mortgages, the more common and lower-rate option, apply a penalty if you break the term early, though most include annual prepayment privileges you can use penalty-free.
How much is a typical prepayment penalty?
On a variable-rate mortgage, expect roughly three months' interest, about $5,625 on a $500,000 balance at 4.5%. On a fixed-rate mortgage, the interest rate differential can push the figure well into five figures. Always ask your lender for an exact quote in writing.
Can I avoid the penalty by porting my mortgage?
Often, yes. Porting moves your existing rate and term to your new property, so there is no break and no penalty. It depends on your lender's rules, your timing between closings, and whether the new mortgage amount fits, so confirm the details before you sell.
Does the penalty come out of my sale proceeds?
Yes. On a sale or refinance, your lawyer pays the balance and the penalty from the closing funds and registers the discharge. You do not usually write a separate cheque, but the penalty reduces the net proceeds you receive.
Are prepayment penalties the same at every lender?
No. The three-months'-interest method is fairly consistent, but lenders calculate the IRD differently, using different comparison rates. Two lenders can quote very different penalties on an identical balance, which is why the written quote matters.
About the author
Joel Fox is a co-founder and COO at Ownright. He helps run the firm's day-to-day work on Ontario residential closings, refinances, and sales, and writes regularly to demystify the parts of a transaction that most homeowners only encounter once or twice in their lives.
At Ownright, we focus entirely on Ontario residential real estate law, helping homeowners with purchase closings, refinances, and sales through a digital platform backed by licensed Ontario lawyers. When you refinance or sell, we handle the mortgage payout and discharge so the numbers are clear before closing day. You can start your closing online or get in touch with any questions.
Legal references: Interest Act, R.S.C. 1985, c. I-15, s. 10; Bank Act, S.C. 1991, c. 46 (cost of borrowing disclosure requirements).
Important note: This article is not legal advice. No one should act, or refrain from acting, based solely on the information in this post or any linked materials without first seeking appropriate legal or professional advice.
