(Note: This article is part of a series of articles on the subject of mortgage penalties. It may be that your question on penalties may be better answered in another article. The list of the other articles on penalties can be found at the end of this article.)

There are two ways that mortgage lenders figure mortgage penalties. Needless to say, since there are two ways, they will choose the one that is most advantageous for them.

1. Number of months interest penalty (2, 3 or 6 months). It is necessary to separate the interest piece of your mortgage payment from the principal and then multiply it by the number of months designated for the penalty.

Example: If a borrower has a 25 year, $200,000 mortgage at 5.4%, and he pays it off after 30 months. His monthly payments are $1,209.17, and the interest for the 30th month is $846.18. If the penalty is three months, the total penalty will be $2,538.55 ($846.18 X 3).

2. Rate differential calculation. This is actually the difference between the rates for the balance of the loan. This is more complicated to calculate, but the logic of it is easy to see. This calculation is used when the rate in force at the time you break your loan contract is lower than the rate on your loan when negotiated. The penalty is figured as the difference between the mortgage interest rate on the old loan and the amount the bank will make on a new loan at this time. Here is an example to see it better:

Example: If we have the same mortgage, $200,000 25 year amortized 5 year mortgage with a rate of 5.4%, the monthly mortgage payment is $1,209.17. If the borrower breaks the contract after 30 months by prepaying the loan, the lender will charge a penalty because he can at this point only lend at the current interest rate, which, 30 months after the old loan, is now at 4.75%.

The calculation works like this:

a. The lender expected to receive a certain amount for the original loan, which was at 5.4%. Using a financial calculator, this amount is calculated at $25,447.16, representing the payment from the 30th month through the 60th month (5 years).

b.The amount of interest that that bank can receive now if it lent the money at the rate of 4.75% for the 31 month period (30th payment through 60th payment) is calculated, again using a financial calculator, at $22,250.74.

c. Finally, the lender will calculate the difference between these two numbers, since this represents the loss they will have between the earnings on the old loan and what they will earn on a new loan at current rates. This is a simple calculation: $25,447.16 less $22,250.74 equals $3,196.26, and that is the penalty the bank will charge to the borrower.

To better understand the penalty:

No borrower wants to pay a penalty on his mortgage! That's for sure, but all mortgage loans, apart from some unusual types of open mortgages, have penalties for prepayments. The question of penalties includes many aspects which need clear explanation and examples in order to be able to fully comprehend them.