Mortgage Prepayment Penalties: IRD vs Three Months' Interest
Whether you should pay the penalty to catch a lower rate is a renewal question: the 2026 renewal guide. The reason fixed terms carry this risk, and many variable terms do not, is the fixed versus variable framework. Both sit under the Canadian mortgage guide. Using your annual penalty-free privilege instead of breaking the mortgage is the prepayment versus investing guide.
- FCAC says the charge is usually the higher of three months' interest on what you still owe, and the interest-rate differential. Lenders differ. Federally regulated lenders must describe the method, and they post a calculator.
- Three months' interest in the FCAC example is balance times contract rate times 3/12.
- A plain differential compares your contract rate with the lender's current rate for the time left. A big-bank differential often compares your contract rate with the current posted rate minus the discount you were originally given.
- On September 23, 2026, the posted 5-year conventional rate in the Bank of Canada series was 6.09%. That sticker is why a discount exists. This page does not quote your discount or your break fee.
- Closed variable contracts are often three months' interest only. TD describes its own variable that way. Confirm yours.
How does FCAC's example work?
| Input | FCAC's figure |
|---|---|
| Balance | $200,000 |
| Contract rate | 6% |
| Time left | 36 months of a 5-year term |
| Lender's current posted rate for a 36-month term | 4% |
| Three months' interest | $200,000 × 6% × 3/12 = $3,000 |
| Interest-rate differential | $200,000 × (6% − 4%) × 3 years = $12,000 |
| Penalty | $12,000, the higher of the two, plus any administration fee the contract adds |
Source: FCAC, "Mortgage fees: Prepayment penalties," as reviewed September 2026. FCAC tells you to use your lender's calculator because the method varies.
Why does the discount make the penalty larger?
Many bank contracts do not compare your contract rate with the rate a new borrower would actually pay. They compare it with a posted rate, then subtract the discount you received when you signed. If posted rates fall, you can owe a differential even though today's discounted rates look close to your contract rate.
Contract rate 5%. Original posted rate 7%, so the original discount was 2 percentage points. Three years remain. Assume the lender's current posted rate for a 3-year term is 5%. The comparison rate is 5% minus the 2-point discount, which is 3%. The differential is 5% minus 3%, which is 2 percentage points. On a $300,000 balance the simple differential is $300,000 × 0.02 × 3 = $18,000. Three months' interest is $300,000 × 0.05 × 3/12 = $3,750. The penalty in this illustration is $18,000.
Change the current posted rate and the penalty changes. The lender may also exclude the slice you are allowed to prepay for free, and it may use a day count that is not "years times balance." The chartered-bank posted 5-year rate of 6.09% on September 23, 2026 is evidence that a posted sticker sits well above many contracts. It is not the 7% or the 5% in this illustration, and it is not your penalty. Run the calculator on the lender's site. FCAC says federally regulated institutions have to provide one.
If the term is longer than five years, ask whether you can prepay after five years with a penalty capped at three months' interest. That right sits in the Interest Act for mortgages on real property, and the contract should not waive it away for an individual borrower. Confirm it against the statute and the mortgage before you treat a 10-year term as a 10-year lock.
When is the penalty worth paying?
Divide the penalty by the monthly payment you would save. That is the number of months the new rate has to stay in force before the break-even, ignoring tax because personal mortgage interest is not deductible. A $12,000 penalty that saves $285 a month, the one-point gap on the illustrative $500,000 loan in the fixed versus variable guide, takes about 42 months to earn back. If the remaining term is shorter than that, paying the penalty to refinance loses even before legal fees.
At maturity the penalty is usually zero, which is why the renewal guide tells you to shop then. Before maturity, a blended rate from your current lender often folds the differential into the new rate. Ask for both numbers: the cash penalty, and the blended rate with the penalty priced out. The TFSA and RRSP comparison is the alternative use of a lump sum you were going to use as a penalty-free prepayment. Debt you could clear at a higher interest rate is the debt payoff guide.
Frequently asked questions
Is the penalty always the interest-rate differential?
It is the higher of the two charges in the usual fixed-rate formula, and three months' interest wins when it is larger. That happens when your contract rate is close to, or below, the lender's comparison rate. Variable closed mortgages often skip the differential and charge three months' interest. The commitment is the authority. FCAC's $12,000 figure is an example of the differential winning.
Why is my bank's penalty bigger than an online calculator?
Online calculators often use a simple gap between two rates. Bank contracts often subtract your original discount from today's posted rate, which widens the gap. They also choose which posted term matches the time you have left. Use the calculator on your own lender's site, and ask which posted rate and which discount went into it.
Can I avoid the penalty with my prepayment privilege?
You can usually prepay a stated percent of the original balance, or increase the payment, once a year without a charge. The penalty applies to the amount above that privilege. If you are breaking the mortgage anyway, ask the lender to apply the privilege first so the differential is calculated on a smaller balance. The privilege does not erase a full discharge.
Does the penalty change if I sell the house?
A sale before the end of a closed term is a prepayment. The same charge usually applies, unless the mortgage is portable and the new lender lets you move it to the next house. Porting has conditions, including a new application and a deadline. Read the portability clause before you waive conditions on a sale.
Are insured mortgages charged a smaller penalty?
Some insured contracts limit the charge. Many do not. The insurer is not the one who writes your penalty clause. The lender does. Ask for the clause, and do not assume a high-ratio mortgage is three months' interest unless the contract says so.
Is the penalty tax deductible?
A penalty on the mortgage for the home you live in is personal, in the same way the interest is personal. A penalty on a loan whose current use is earning rental or investment income can be treated differently. That is a tracing question for the year you pay it. The HELOC and rental pages on this site are the neighbouring guides, and they are not a ruling on your file.
Sources
- FCAC: mortgage prepayment penalties, including the $200,000 example
- FCAC: prepayment rights
- TD's description of its IRD and three-month charge
- Interest Act, section 10 (prepayment after five years)
- Bank of Canada posted 5-year conventional rate
A penalty is a cash cost. The interest behind it may or may not be deductible.
Personal mortgage interest is not a carrying charge. Investment-loan interest can be. The 2026 tax guide is where that line gets filed.
Get the 2026 Tax Guide — $49 CAD
