It’s remarkable to consider how far mortgage rates in Canada have dropped in such a short time. If you happened to get a 5-year fixed mortgage in July of 2009, the best rate available was 4.24 per cent, compared 2.99 per cent today. These low rates are tempting many Canadians to break their mortgage and lock in a better rate.

The problem with an early mortgage refinance  is you’ll be subject to a mortgage penalty and calculating this penalty is not always clear.

How to calculate your mortgage penalty

The easiest way to calculate your penalty is to use a mortgage penalty calculator. You will also need to know certain variables such as your mortgage start date, current remaining mortgage balance and the original term of your mortgage. Let’s look at an example and assume you acquired a 5-year fixed mortgage rate at 4.24 per cent from CIBC in July of 2009 and currently have an outstanding mortgage balance of $300,000. Using an online mortgage penalty calculator, your estimated penalty fee would be $8,470 if you wanted to break your mortgage today (see below for calculations).

How the calculation works

Many mortgage consumers are unsure how lenders calculate their mortgage penalties. A common myth is that it is three months’ interest; however the reality is that it really depends on what type of mortgage you have. A variable rate mortgage will use the equivalent of three months’ interest whereas a fixed rate mortgage will use the greater of either three months’ interest or the interest rate differential (IRD). The example above was calculated using the IRD.

The interest rate differential is a bit more complicated because it is less straight-forward than three months’ interest. Some lenders will use your actual mortgage rate in the calculation and others will use the posted rate at the original time of your mortgage contract. If you have a mortgage with CIBC as in the example above, the 5-year posted rate at the time you signed your original mortgage contract would have been used in the IRD calculation, which in July of 2009 was 6.75 per cent. If your mortgage was through ING Direct, your actual mortgage rate would have been used instead, which would have resulted in a different penalty total (using the same numbers from the example, the mortgage penalty would have been approx. $5,445).

What to do with the information

We should point out that in today’ s falling interest rate environment, a mortgage penalty calculated with IRD is almost always a larger penalty than three months’ interest. And a large mortgage penalty could erase what you might’ve saved by refinancing at a lower mortgage rate. If you do find a great mortgage rate, you need to understand that there are a number of other factors to consider in addition to the mortgage penalty. To truly determine whether it’s worth it for you to break your mortgage contract early or not, you should consult a professional mortgage broker.