Selling before your term ends, refinancing to a lower rate, or paying off a large chunk beyond your privileges usually means “breaking” your mortgage, and paying a prepayment penalty.
Variable-rate mortgages
Almost always three months’ interest. On a $400,000 balance at 6%, that’s 400,000 × 6% × 3 ÷ 12 = $6,000.
Fixed-rate mortgages
The greater of three months’ interest or the interest rate differential (IRD). The IRD compensates the lender for re-lending your money at today’s lower rate for the rest of your term:
IRD ≈ balance × (your rate − comparison rate) × months remaining ÷ 12
Example: $400,000 at 5.00%, comparison rate 3.50%, 24 months left. IRD = 400,000 × 1.5% × 2 = $12,000, more than the $5,000 three-month figure, so the penalty is $12,000.
Why bank penalties can be shocking
Many large banks set the comparison rate at their posted rate for a term close to your remaining term, minus the discount you received when you signed. If you got a 1.5% discount off a posted rate, that discount is subtracted again, which can double or triple the IRD. Monoline lenders often use their actual current rates instead, producing much smaller penalties. Read the prepayment section of your mortgage before choosing a lender.
How to reduce the penalty
- Use this year’s prepayment privilege first.
- Port the mortgage to your next home.
- Blend and extend with your lender instead of breaking.
- Time it: IRD falls as the remaining term shortens.
- Ask for the exact figure in writing; federally regulated lenders must provide it.
Get a ballpark first with the penalty calculator.