Prepayment privileges allow a borrower to prepay a portion of the mortgage principal before it’s due without a penalty. There are limitations to this. It’s basically paying more than your agreed upon mortgage payment and is applied directly to the principal amount owing.
Types of Prepayment Privileges
If you have an open mortgage, you can pay anything over the agreed-upon mortgage payment. Any prepayment goes directly toward paying down the principal. This is a great feature but typically carries a higher interest rate since it can be paid off at any time.
Closed mortgage prepayment options vary among lenders. Lump-sum payments, payment double-ups, and scheduled increases to their regular mortgage payment amount are few.
Using a tax refund is a way to make a lump sum payment towards your mortgage and significantly reduces your interest costs.
Many borrowers don’t have the means to do a large lump sum payment. This is why lenders allow lump-sum payments of a minimum of $100.00.
Some lenders calculate this period from the calendar year to the calendar year. Others calculate this period from the anniversary date to the anniversary date. Terms of making prepayments can range from 10% to 20% of the original mortgage amount each year.
Lump-sum payments have a greater impact on your mortgage, even more than just increasing your regular mortgage payments. Each lump sum you make is applied directly to the principal of your mortgage.
This reduces the amount of interest you pay each month and in turn, reduces your scheduled amortization period. We all dream of making lump-sum payments, however, it’s not realistic for many. This is why its easier to increase your regular payments to have a small amount going towards principal each payment date.
Paying your mortgage in either a biweekly or weekly payment also helps to chip away at your mortgage balance.
Some lenders offer a “skip a mortgage payment” option, with restrictions on how many times each can occur in a specific period.
Closed vs Open mortgage terms
A closed mortgage provides a lower interest rate however if you sell before the term is up, your lender will charge you a prepayment penalty. This is because you are breaking your agreed upon contract before its date. This means the lender is missing out on the interest you have agreed to pay them. Open mortgages come with a higher interest rate, however, can pay it off at any time with no penalties.
How Are Prepayment Penalties Calculated?
In Canada, prepayment penalties on closed mortgages are calculated either 3 months interest or the interest rate differential (IRD), whichever is greater for the lender.
Lenders calculate these (IRD)’s very differently which can often outweigh any savings you may have had acquiring a lower rate.
Some lenders calculate the payout penalty based on the contract rate. Some base it on the bank’s posted rate for the remaining term.
Say you have a 5-year mortgage, 2 years later you sell because you have lost your job. You would still owe the bank for 3 years of interest. If you were paying the bank 6% interest and they can now only lend money out at 4%, you have to pay back the difference. The greater the time left on the term, the greater the IRD penalty, as the difference in interest is incurred for a longer period of time.
Life is unpredictable, and curveballs come out of nowhere. If you find yourself in a situation where you need to break your mortgage, there are a few ways to help reduce the penalty. Knowing what these penalties could look like before you choose your mortgage lender is of key importance.
An interest rate could be the same amongst a couple of lenders but the payout penalties can be significantly different. Working with a trusted mortgage advisor who can show you how the same mortgage with 5 different banks penalties could look like. Some are much higher than other and you want to make sure you make the right choice in the very beginning.