An Alberta borrower is considering breaking their 5-year fixed mortgage in year 3 to refinance at a lower rate. How is the prepayment penalty typically calculated for a fixed-rate mortgage?

Q: What is the correct answer to: An Alberta borrower is considering breaking their 5-year fixed mortgage in year 3 to refinance at a lower rate. How is the prepayment penalty typically calculated for a fixed-rate mortgage?

The correct answer is The greater of three months' interest or the interest rate differential (IRD) calculated on the remaining balance and term. Option B correctly states the standard penalty formula: the greater of three months' interest or the IRD. Under Canadian federal lending regulations, fixed-rate mortgage lenders typically use this dual-calculation method. The IRD reflects the lender's lost revenue based on the rate spread over the remaining term, applied to the outstanding balance.

Q: What background knowledge is needed for this Mortgage & Real Estate Finance question?

Fixed-rate mortgage prepayment penalties in Canada use the greater of two calculations: three months' interest on the outstanding balance, or the interest rate differential (IRD). The IRD compares the original contract rate to the current rate for the remaining term, applied to the outstanding balance. When rates drop significantly, the IRD can produce penalties of tens of thousands of dollars, far exceeding three months' interest.

Q: What is a good way to remember the answer to this Mortgage & Real Estate Finance question?

Fixed penalty = MAX(3 months' interest, IRD). The lender always picks the BIGGER number. When rates drop, IRD dominates and the penalty can be enormous. On exam questions about breaking a fixed mortgage, look for the 'greater of' formula. Any answer with a flat fee or no penalty is automatically wrong for fixed-rate mortgages.

Q: What exam tip applies to this Mortgage & Real Estate Finance question?

Variable-rate mortgages typically charge only three months' interest as a penalty, while fixed-rate mortgages use the greater of three months' interest or IRD. Know the difference for exam day.

Q: How does this Mortgage & Real Estate Finance concept apply in real world practice?

An Alberta borrower has a $400,000 fixed mortgage at 5.5% with two years remaining. Current two-year rates are 3.5%. Three months' interest equals $5,500, but the IRD calculation yields approximately $16,000 based on the 2% rate spread over two years. The lender charges $16,000—the greater amount—making refinancing less financially attractive.

Question

Mortgage & Real Estate FinanceABHARD

An Alberta borrower is considering breaking their 5-year fixed mortgage in year 3 to refinance at a lower rate. How is the prepayment penalty typically calculated for a fixed-rate mortgage?

Answer Options

A

A flat fee of $1,000 regardless of the mortgage balance

B

The greater of three months' interest or the interest rate differential (IRD) calculated on the remaining balance and term

C

1% of the original mortgage amount

D

No penalty is charged in Alberta due to consumer protection laws