Prepayment Penalties in Canadian Mortgage Law

Abstract

Mortgages provided by Canadian banks impose prepayment charges of at least three months' interest if the mortgage is paid off before it expires. That charge is imposed even if the bank profits from the mortgage being repaid early, as would be the case when market interest rates have risen. This is a one-sided term that appears to reflect an imbalance of bargaining power between lenders and borrowers.

The most common reason for prepaying a mortgage is that the property is being sold. The standard mortgage terms also include a "due on sale" clause that frequently triggers prepayment charges. The bank purports to be able to prevent the borrower from selling the property without first paying off the mortgage. The existing mortgage cannot be assumed by a new purchaser without the lender's approval, and it can arbitrarily withhold that approval. Given their large diversified portfolio of mortgages, and the other remedies available, banks do not require this degree of control from a risk perspective. Their main motivation for inserting the clause is likely to be the increased profits generated by prepayment charges.

Even though almost all mortgages contain this clause, there has not been a single reported case in Ontario, since 1960, of a lender attempting to sue a borrower for breaching this term. This raises a suspicion that they have overlooked breaches because they are not confident of its enforceability. Applying the principles of equity to the mortgage contract suggests that it ought not to be enforceable. Legislation should be amended to clarify this situation for the benefit of borrowers.

Keywords: mortgage law, contract law, unconscionability, consumer protection, banking

JEL Classification: K12, G21, D18