Calculating Payout Penalties & Interest Differentials

Many closed mortgages include a clause stating that the payout privilege on the mortgage will be a three-month interest penalty, or interest differential, whichever is greater.

For the calculations below, we’ll use the following scenario:

  • $300,000 remaining on the mortgage
  • 3 years into a 5-year fixed term at 5.5%
  • Today’s interest rate: 3.5%

We’ll just be using the simple interest amount – the actual amount of the penalty would be a little less than the amount quoted in the examples.

Three Month Interest Penalty

Interest Penalty

Plugging in the variables above, we would get:

=   $300,000   X   0.055    X   0.25                (5.5% = 0.055,  3/12 = 0.25)

= $4125.00 would be the 3 month interest penalty

But now we have to calculate the interest differential – and that’s where it can get nasty – especially since interest rates have dropped considerably lately.

Interest Differential Penalty

Interest Differential
=$300,000 X 0.02  X 2
(0.02 = 2% which is the difference from 5.5%-3.5%, and 2 years left in term)

=$12,000.00 would be the Interest Differential Penalty

In our example, the bank would then use the Interest Differential Penalty since that amount is the greater of the two. Please speak to your mortgage specialist for your personalized mortgage advice, as payout penalties are dependant on the contract you signed.

6 responses to “Calculating Payout Penalties & Interest Differentials

  1. Leah Van Loon

    So in this scenario the penalty is applied for paying off the remaining $300 000? Sorry for my mortgage ignorance but I don’t have one yet!

    Mike Fotiou says: Don’t apologize! 🙂 That’s what this blog is for.

    Yes, in this scenario that would be the penalty for paying off the balance before the end of a fixed term, or perhaps if you were thinking of refinancing to a lower interest rate and were wondering if it would save you money after the penalty was applied. Again, it all depends on the terms of your mortgage contract.

    Some mortgages are portable too, so if you sell your house and buy another, you can just “move” the mortgage over, add the difference to the mortgage amounts and have the interest rates blended. Your mortgage specialist is much more knowledgeable about the various mortgage products out there – and it doesn’t cost you anything to use their great services, which is a bonus!

  2. when calculating interest difference, you mention “today’s rate”, is that rate the fixed rate for 5 years?
    thanks

  3. Hello Sam,

    In the scenario used, yes it was the 5 year fixed at the time. You have to adjust the scenario to your fixed term and your lenders rates.

  4. Thanx Mike.. If i were to sell my house, and the fixed interest rates have gone HIGHER, would the bank still use interest rate differential formula to calculate my penalty? or they use this formula only when interest rates go lower?
    Thanks again, I appreciate it

    Mike Fotiou says: They would probably apply some sort of payout penalty – you would have to check with your lender and see what exactly that would entail. If interest rates were higher when you sold than what your rate was, they’d probably charge the 3 months interest penalty, but again, it just depends on your lender/mortgage terms.

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  6. Just to add.

    Just recently got information about breaking my mortgage and I was aware of this formula that you have. However, the rate that the bank used to calculate my interest differencial penalty confused me.

    Principal balance that I had was $159,500.00 at interest rate of 4.34% and 4 year term. 28 months or 2.33 years was remaining. Based on the bank the penalty for breaking my contract would be $6,428.97. I though this has got to be wrong. So I asked why and this is what I found out after they put me on hold for a long period of time.

    1) My bank (RBC) used current interest for 3 year term (3.89%) rather than a 4 year term (5.04%). The closest term to the remaining time for the contract.
    2) Rather than 4.34%-3.89%, they calculated 5.69%-3.89%, because they say that I was given a 1.35% discount on my mortgage when I signed.

    Is it legal for them to do that?

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