What are Closed Mortgage Penalties

It seems like the public has suddenly been spooked about mortgage rates, because my phone is ringing off the hook. Everyone wants to be renewing their mortgage for the long-term to protect themselves from rate hikes. Unfortunately, so many of these clients seem to forget that they have already locked themselves into long-term agreements for the next few years.

For many of these requests, I find myself re-explaining how it is that a closed-term mortgage comes with some pretty ugly repayment penalties. While this only eliminates a handful of options available to the client, it is important to understand exactly how a closed mortgage works, and what paths are available during a period of time in which we feel might be immediately preceding some volatility.

When a borrower locks in a closed mortgage for a period of time, they are explicitly agreeing to pay a certain amount of interest and principle, over specific intervals, for a specific period of time. The reason why the lender will provide more favorable rates of interest for this sort of agreement is then because of the way in which the loan requires less effort and management on their end.

They can easily predict and apply the incomes from the loan, and also don’t need to worry about the customer running off with a competitor for at least the duration of the loan. As such, lenders will include a very heavy repayment penalty for when a client wants to remove themselves from the agreement early.

These fees can be as much as 15% of the value of the home, depending on the term and principle remaining on the loan. As such, it is important for us to recognize when it is that these penalties will be incurred.

Whenever a client wants to sell their home, transfer their mortgage to another financial institution, or pay off the value of their mortgage in a lump-sum transfer, they will incur pre-payment fees. However, borrowers will generally be allowed to renew their mortgage early without penalty, so long as it keeps the business with the original lender.

This means that a borrower who is concerned about rising interest rates may renew their loan at their existing institution in order to lock in the rate without detriment, and may also extend the term of their agreement in order to decrease their exposure to future interest rate fluctuations.

What’s more, because the client is renewing, the borrower may be able to lower their existing interest rate even further if prime has decreased over the current period. This being said, lenders will not allow a borrower to renew their mortgage for a shorter term than what is remaining. This means that a borrower with 3 years remaining on their current agreement term cannot renew for a period that is less than 3 years in length. They will need to renew for a period of 4 or more years.

As borrowers, we can take advantage of this information in a number of ways. Between locking in lower rates, reducing exposure to fluctuations, and potentially even reducing payment amounts, a borrower can find ways to ensure that their mortgage is stable. From here, we are able to increase the breadth of the discussion to include strategies for managing prepayment fees as a sophisticated property buyer.