The standard approach for a closed, fixed-rate Canadian mortgage is to charge whichever is greater: three months' interest, or the interest rate differential (IRD). The two formulas measure different things, and the lender is compensated by whichever number is bigger in a given situation — never by adding the two together. Understanding both formulas, and understanding what makes each one larger or smaller, is what lets a broker explain a penalty quote to a client instead of just reading it off a lender's letter.
Three months' interest is exactly what it sounds like: the borrower's contract interest rate, applied to the outstanding balance, for three months. On a $400,000 balance at a 5.00% contract rate, that's $400,000 × 5.00% ÷ 12 × 3 months, or $5,000. This number doesn't care how much time is left in the term, and it doesn't care whether rates have moved since the mortgage was signed — it's the same $5,000 whether there's four years left on the term or four weeks.
The interest rate differential exists because a lender that locked in a rate with a borrower has effectively agreed to lend that money at that rate for the full term. If the borrower leaves early and rates have since fallen, the lender is left having to relend that money at a lower rate for whatever time was left — the IRD is a rough approximation of that lost interest. In simplified form: take the gap between the contract rate and a comparable rate for the time remaining, multiply by the outstanding balance, and multiply by the fraction of the term still remaining, in years.
Worked example: a $400,000 balance, a 5.00% contract rate, a comparable rate today of 3.50% for the roughly three years left in the term, is a 1.50-point gap. IRD ≈ $400,000 × 1.50% × 3 years = $18,000. Compare that to three months' interest on the same file — $5,000 — and the lender charges the greater figure, the $18,000 IRD.
Take that same $400,000 balance and the same 5.00% contract rate, but now imagine only two months remain in the term and rates have fallen by a full point, to 4.00%. IRD ≈ $400,000 × 1.00% × (2 ÷ 12 of a year) ≈ $667 — a small number, because there's almost no time left for the lender to actually miss out on interest. Three months' interest on the same file is still $5,000, calculated the same way regardless of time remaining. Here the lender charges the $5,000, because it's the greater of the two.
The general pattern worth internalizing: IRD scales with both the size of the rate gap and the amount of time left in the term, so it tends to dominate earlier in a term when a meaningful rate drop has occurred. Three months' interest doesn't scale with time remaining at all, so it tends to dominate near the end of a term even when the rate gap is sizeable, simply because there isn't enough time left for the IRD side of the comparison to catch up.
Under the Financial Consumer Protection Framework Regulations that apply to federally regulated lenders, a mortgage credit agreement's initial disclosure has to include the amount of any prepayment penalty and a brief explanation of how it is calculated. That's a real, if fairly general, disclosure obligation — it doesn't mandate a specific worked example or a simplified estimator, just a plain explanation of the method. Because the baseline disclosure can be brief, a broker who can actually walk a client through the real math, the way this module does, is offering something meaningfully more useful than the minimum a lender is required to hand over.
A client is two months from the end of their fixed term, and rates have dropped substantially since they signed. Which penalty formula is more likely to apply?
IRD is a function of both the rate gap and the time remaining — with only two months left, even a large gap produces a small dollar figure, because there's so little time left for the lender to actually be missing out on interest. Three months' interest doesn't care how much term is left, so it tends to win exactly in this situation. The lender charges the greater of the two, not both, and there is no general exemption from penalties simply for being close to maturity — a client that close might be better served waiting the short remainder out instead of breaking at all, which is a conversation worth having before assuming a break is the goal.
