Prepayment penalties: how they are calculated

Why a penalty exists

When you borrow at a fixed rate for a term, the lender counts on the interest from that whole period. An early repayment removes that income.

The penalty makes up for that loss. It is written into the contract you sign.

This guide describes the common mechanisms. The figures on your loan depend on your contract.

The two most common formulas

The Financial Consumer Agency of Canada (FCAC) explains that the penalty is usually the higher of two amounts.

• Three months’ interest on the balance you still owe
• The interest rate differential, or IRD

The IRD compares the interest left to pay over the term at two rates: yours and a current rate. The gap is multiplied by the balance and by the time remaining.

According to FCAC, lenders often apply the IRD when your rate is higher than the current rate. They do so mostly if you signed less than five years ago.

One FCAC example uses a $200,000 balance at 6% with 36 months left. Three months’ interest comes to about $3,000. The IRD comes to about $12,000. The penalty would therefore be $12,000.

That example describes a loan to an individual. Your commercial loan may follow a different formula.

What makes the IRD move

FCAC notes that the IRD often rests on banks’ posted rates. When those rates change, the penalty can change a lot.

Each lender has its own way of choosing the comparison rate. Two similar loans can therefore carry different penalties.

Read the definition of the comparison rate in your contract. Ask the lender to confirm it in writing.

Lock-in clauses and prepayment privileges

A closed loan limits repayments during the term. An open loan allows them with no penalty, according to FCAC.

Prepayment privileges sit between the two. They let you repay a set amount each year at no charge.

• Raising the regular payment by a set percentage
• Paying a lump sum up to a ceiling
• No carrying unused amounts over from one year to the next

These rules are in your contract. Each lender sets its own.

BDC also lists limits on early repayment among the possible costs of a commercial mortgage. Look in your contract for the clause that sets the closed period.

Making your own estimate helps you ask the right questions. Three months’ interest is worked out as follows: balance, times the annual rate, divided by four.

On a $400,000 balance at 5%, that gives about $5,000. This is an arithmetic example, not an offer. It does not replace your lender’s figure.

FCAC notes that the penalty sometimes includes an administration fee. The exact formula remains the one in your contract.

A commercial lender may add its own mechanisms. Read the clause from start to finish, including the definitions.

What the law says

The Interest Act, a federal law, has a rule that touches mortgages on real property. Here is what the text provides, as published by the Department of Justice.

Take a mortgage whose principal is not payable until more than five years later. After those five years, the borrower may repay it. The borrower pays the amount due plus three months’ further interest in place of notice. No further interest is owed after that.

This rule has exceptions. The Act excludes certain mortgages and hypothecs given by joint stock companies or other corporations.

If your business is a corporation, do not assume the rule protects you. Ask a notary or lawyer whether it applies to your hypothec.

The same Act bars fines or penalties on arrears that would push the cost above the rate on principal. That is a separate matter: it covers late payments, not early repayment.

In practice, this rule matters mostly for long terms. A term of five years or less does not reach it, since the five years must pass first.

Check the date on the hypothec and the date the principal falls due. Those two dates decide whether the rule is even in play.

How to reduce or avoid the penalty

FCAC offers several ways, described for loans to individuals. They are worth asking about on a commercial loan.

• Use your prepayment privileges in full each year
• Wait until the end of the term for a large repayment
• Move the loan to a new property, if the contract allows, instead of breaking it
• Ask the lender for a blend-and-extend

In a blend-and-extend, the lender extends your term before it ends. FCAC says this is usually done without a penalty, though administrative fees may apply.

A partial repayment follows the same logic. FCAC explains that a penalty can apply if you exceed the amount your privileges allow.

Selling the property also triggers a full repayment. FCAC lists a sale among the cases where a penalty can apply. If you plan to sell, read the clause before you buy, not after.

Finally, FCAC says some lenders restrict lump-sum payments close to the break date. Make your payments well ahead.

What to do next

Before signing a loan, find the closed period, the penalty formula and your privileges in the contract. Before repaying, ask the lender for the exact amount in writing.

Add the discharge and administration fees to the total. The guide on hidden costs of a commercial loan lists them.

PMECAP is a free comparison site and does not lend. The refinancing and commercial financing guides explain how a request is passed to a mortgage brokerage registered with the AMF.

FAQ

Sources

• ACFC : pénalités de remboursement anticipé (accessed October 13, 2026)
• ACFC : rompre son contrat hypothécaire (accessed October 13, 2026)
• ACFC : comparution devant le Comité des finances, 7 juillet 2020 (pénalités) (accessed October 13, 2026)
• Justice Canada : Loi sur l’intérêt (art. 8 à 10) (accessed October 13, 2026)
• BDC : prêt hypothécaire commercial (glossaire) (accessed October 13, 2026)