Understanding Mortgage Break Fees: A Simple Guide

A mortgage break fee is a penalty fee charged by lenders when borrowers break their mortgage contract by repaying a fixed-term mortgage early. This can occur when selling a house or refinancing to get a better deal. The fee covers the legitimate cost incurred by banks when borrowers break their loan terms. The fee amount depends on the size of the mortgage and the interest rate environment. In a falling interest rate environment, borrowers may be tempted to break their mortgage contract to benefit from lower interest rates. However, it is important to consider all costs and benefits before making a decision, as break fees can cost thousands of dollars.

Variable vs. fixed-rate mortgages

When considering a mortgage, it's important to understand the differences between variable and fixed-rate mortgages to save money and meet your financial goals. A fixed-rate mortgage offers stability and predictable payments, while a variable-rate mortgage provides the possibility of lower costs and more flexibility.

With a fixed-rate mortgage, your interest rate and monthly payments remain the same throughout the loan's term, regardless of broader market trends. This predictability makes budgeting easier, as you know exactly how much your monthly payment will be. Fixed-rate mortgages protect borrowers from sudden increases in monthly payments if interest rates rise. However, they usually come with higher interest rates and lock you into those rates for the loan's duration. If interest rates drop, you'll need to renew or refinance to obtain a lower rate, which may involve fees. Additionally, breaking a fixed-rate mortgage contract early can result in significant prepayment penalties.

On the other hand, a variable-rate mortgage's interest rate fluctuates based on underlying benchmarks or market interest rates. This means your monthly payments can vary, creating uncertainty and risk for the borrower. Variable rates have typically been lower than fixed rates initially, and if interest rates remain the same or fall during the loan term, you'll pay less interest over time compared to a fixed-rate mortgage. Variable-rate mortgages often come with smaller penalties for breaking the contract early, usually equivalent to three months' interest. They also offer the flexibility to switch to a fixed-rate mortgage if desired.

It's worth noting that variable-rate mortgages come in two main types: adjustable-rate mortgages (ARMs) and fixed payment variable-rate mortgages. With an ARM, your interest rate and payments can increase or decrease sharply in response to market trends. The popular 5/1 ARM maintains a fixed interest rate for the first five years, after which the rate adjusts annually. In contrast, a fixed payment variable-rate mortgage keeps your monthly payment the same even if rates change. If rates rise significantly and your payment no longer covers the interest charges, you'll need to negotiate with your lender.

When deciding between a variable and a fixed-rate mortgage, consider your financial goals and risk tolerance. Variable-rate mortgages offer more flexibility and the potential for lower costs, but they come with the risk of higher payments if interest rates rise. Fixed-rate mortgages provide stability and predictable payments but may be more expensive and less responsive to market changes. Additionally, consider the current interest rate environment and your expectations for future rate movements. If you anticipate interest rates falling, a variable-rate mortgage could be advantageous, while a fixed-rate mortgage may be preferable if you expect rates to rise.

Prepayment penalties

A prepayment penalty is a fee that some lenders charge if you pay off all or part of your mortgage early. This fee is designed to incentivize borrowers to pay back their principal on schedule for a loan's entire term, allowing mortgage lenders to collect their planned interest. Prepayment penalties are added to a mortgage contract to protect lenders from the loss of interest payments over the life of the loan. The first few years of a loan term are riskier for the lender than the borrower.

There are two types of prepayment penalties: soft and hard. A soft prepayment penalty only applies when you refinance or pay off a large chunk of your mortgage loan during the loan's early years. You can sell your home without incurring a penalty. A hard prepayment penalty applies to any prepayment, including refinancing, paying off a significant portion of your loan, or selling your home.

Prepayment penalty costs vary depending on the lender and the loan. Here are some common models used by lenders to determine the prepayment penalty's cost:

• Percentage of the remaining loan balance: The lender will assign a percentage, such as 2% of the outstanding principal, as a penalty fee if the mortgage is paid off within the first 2 or 3 years of the loan term.
• Lender-specified number of months' interest: The borrower will pay a specified number of months of interest, such as 6 months.
• Fixed amount: While this payment model is not typically used for mortgages, a lender may set a flat fee, such as $3,000, for paying off a loan within the first year.
• Sliding scale based on mortgage length: This is the most common model. For example, if the mortgage is paid off during the first year, the penalty is 2% of the outstanding principal balance, and if it is paid off during the second year, the penalty is 1% of the outstanding principal balance.

Porting a mortgage

If you are considering porting your mortgage, here is a step-by-step guide to help you through the process:

• Review your mortgage agreement to ensure it is portable.
• Check for any specific conditions or fees associated with porting.
• Notify your mortgage provider about your intention to port and request details about the process, required documentation, and associated fees.
• Ensure that the new property meets the lender's criteria and is valued appropriately.
• The lender may reassess your financial situation, so be prepared to provide proof of income, employment, and any other required financial documentation.
• Submit details about the new property, including the purchase agreement and property appraisal.
• Coordinate the sale of your current property and the purchase of the new one to align with the porting process.
• Await the lender's approval for porting your mortgage to the new property.
• Sign any necessary documents to finalise the porting process.
• Complete the sale and purchase transactions, then move into your new property.

It is important to note that porting a mortgage can be a complex process, and there may be additional costs such as legal fees, appraisal fees, and moving costs. Additionally, if you are moving to a more expensive home, you may need to cover the difference, resulting in a blended interest rate. On the other hand, if you are moving to a less expensive home, you might repay a portion of the mortgage.

Interest Rate Differential (IRD)

An Interest Rate Differential (IRD) is a penalty fee charged by lenders when a borrower pays off or breaks a fixed-rate mortgage before the end of its term. It compensates lenders for the interest they lose when a mortgage is paid off early, ensuring they can recover some of their anticipated earnings on the loan.

The IRD is calculated by multiplying the prepayment amount by the difference between the original mortgage rate and the lender's current rate for a new mortgage term that matches the time left on the original mortgage. This calculation can be complex, with lenders using various formulas, and it is often passed along as a fee to mitigate the opportunity cost of the lender having to loan out the money at a lower rate of interest.

IRD calculations demonstrate the difference in interest rates between two financial securities, typically in fixed-income trading, forex trading, and lending calculations. In the context of mortgages, the IRD is the difference between the interest rates of two similar interest-bearing assets, such as the original mortgage rate and the current interest rate for the remaining term.

When considering breaking a mortgage contract, it is essential to compare the costs and benefits to ensure savings. Lenders may also allow borrowers to extend the length of their mortgage before the end of the term, which can help avoid prepayment penalties. This option, known as "blend-and-extend" or a "blended mortgage," involves blending the old interest rate with the new term's interest rate.

Blend-and-extend options

A blend-and-extend mortgage is a type of blended mortgage that allows you to lower your interest rate without technically breaking your current mortgage contract. This means that you won't be charged a prepayment fee, which could be the case if you refinance or change lenders mid-contract.

With a blend-and-extend mortgage, you can combine your original mortgage rate with a new, lower one. The new interest rate falls somewhere between your old mortgage rate and the rates your lender is currently offering. For example, if you owe $250,000 on your mortgage, with two years remaining on a 5-year term with a fixed rate of 4.50%refinance to take on a new 5-year fixed term at 3.39%. However, to get that rate, you'd have to pay a prepayment penalty of $10,325. To avoid that fee, you could instead blend your existing mortgage rate with the new mortgage rate, resulting in a new 5-year fixed term at a rate somewhere between 3.39% and 4.50%.

A blend-and-extend mortgage can also allow you to access the equity in your home before your current mortgage term is up. This can be used to pay for other things. However, a blend-and-extend mortgage may not always be the best option. For example, if interest rates continue to fall, you might have been better off waiting to renew at an even lower rate at the end of your term. Additionally, a blend-and-extend mortgage cannot be transferred to a new property if you move, and it may not always be the cheapest option.

Before choosing a blend-and-extend mortgage, it is important to consider all the costs involved and compare them with other options, such as breaking your current mortgage contract or choosing a blend-to-term mortgage.

Frequently asked questions