Prepayment privilege’s allows 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 and it goes directly toward paying down the principle. This is a great feature but typically carry a higher interest rate since it can be paid off at any time thus the lender not making as much interest off the borrower.
If you have a closed mortgage, lenders vary in their prepayment options. Some allow lump-sum payments, payment double-ups and scheduled increases to their regular mortgage payment amount.
Making use of the tax refunds is a great way to make a lump sum payment towards your mortgage balance and significantly reduces your interest costs.
Many borrowers don’t have the means to do a large lump sum payment which is why most lenders allow lump sum payments of a minimum $100.00 each year.
Some lenders calculate this period from the calendar year to calendar year while others calculate this period from anniversary date to 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 as each lump sum you make is applied directly to the principal of your mortgage.
This results in immediately reducing 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 which is why its easier to increase your regular payments to have a small amount going towards principle each payment date.
Paying your mortgage in either a biweekly or weekly payment also helps to chip away at your amortization by paying down the mortgage balance quicker.
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
Choosing a closed mortgage with a lower interest rate is great however should you sell your home before the current term is up, you lender will charge you a prepayment penalty as 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. With open mortgage terms with a higher rate, you 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 and some base it on the bank’s posted rate for the remaining term in which you owe the bank.
Say you have a 5 year mortgage term, 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 of the mortgage, the greater the IRD penalty, as the difference in interest is incurred for a longer period of time.
Life is unpredictable, and oftentimes 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 hep reduce your penalty. Knowing what these penalties could look like before you choose your mortgage lender is of key importance.
Your interest rate could be the same amongst a couple different lenders but your 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.