It’s safe to assume that most Canadian homeowners would welcome the opportunity to save money on their mortgage and pay it off faster. Luckily, many mortgage lenders in Canada offer prepayment privileges that will enable you to do so by allowing you to put a specified amount toward your mortgage’s principal in addition to your regular payments – without being charged a prepayment penalty.
In this blog, we’ll tackle the topic of prepayment privileges to give you a better understanding of how they work. Keep scrolling to learn:
- What the prepayment privilege is
- How the prepayment privilege can benefit you
- The difference between open and closed mortgages
- The different prepayment options
- The way lenders differ from one another
- How a mortgage broker can help you put prepayment privileges to use
Let’s get started.
What is a mortgage prepayment privilege?
The mortgage prepayment privilege is a tool that lets you save money and pay off your mortgage faster by allowing you to put extra funds toward the principal of your loan in addition to your regularly scheduled payments. The prepayment privilege is outlined in the mortgage contract and can vary depending on the lender and the mortgage type.
Why is this important?
Because of the mortgage prepayment penalty, which is a fee that you are required to pay when you change or break your mortgage contract prior to maturity, or when you put extra funds in addition to your regular payments toward your mortgage. Luckily the prepayment privilege will allow you to put extra money toward your mortgage without having to pay this fee as long as you stay within the rules outlined in the mortgage contract.
While the fee charged can be a basic three months of interest based on the existing mortgage, typically with variable rate products, many lenders choose to use the interest rate differential (IRD). IRD is the difference between the amount a borrower would pay with their original interest rate vs. the interest rate that the lender offers on the date of the prepayment. It is important to note that lenders will differ in the way they calculate the IRD penalty.
This fee can quickly add up, especially if you are attempting to break your mortgage contract mid-term or even sooner, totaling tens of thousands of dollars. Some lenders have calculations that can cost you 3-4x another lender, so it’s important you understand prepayment privileges when choosing a mortgage.
What are the benefits of mortgage prepayment privileges?
Mortgage prepayment privileges don’t just help you avoid paying a hefty fee if you break or change your contract early, they can also help you to pay off your mortgage faster and save you more money! This is because 100% of any additional payment you make towards your mortgage will go towards paying off the principal. Since the amount of interest paid is tied to the principal balance left on the loan, chipping away at the amount through prepayments will incidentally lower the amount of interest being charged and save you money over time.
Here’s a summary of the benefits the mortgage prepayment privilege offers:
- Helps to reduce the overall length of time you hold a mortgage.
- All payments made go towards paying off the principal, so even small prepayment amounts will have a big impact on your overall home/mortgage cost.
- Provides the potential to pay off some or all of the debt ahead of maturity without a penalty.
Open vs. Partially Open vs. Closed mortgages
One of the main factors determining your prepayment options is whether you choose an open or closed mortgage. Open mortgages allow your mortgage balance to be paid off in full at any time. There are also partially open mortgages which provide the borrower with the right to pay off the loan at any time in full, but are subject to a penalty of either three month’s interest, or interest differential, whichever is determined by the lender. On the other hand, with a true closed mortgage, you cannot pay off the loan early, refinance, or renegotiate the contract during the interest term.
That said, many lenders offer prepayment privileges for partially open and closed mortgages that allow you to increase your regular mortgage payment by a specified percentage, or pay a lump sum each year based on a percentage of the initial mortgage balance without having to pay a penalty. It’s important to know that these privileges will vary from lender to lender.
What are the prepayment options?
Now that we know what mortgage prepayment privilege is and how it can benefit you, let’s look at the available prepayment privilege options.
It’s not uncommon for some banks to allow between 10% to 20% in prepayment privileges payable in a lump sum, payment double-up options or via an increase to regularly scheduled payments
For the most part, prepayment privileges are written as 15/15 or 20/20 in the mortgage contract.
So, what do these numbers mean? The first number represents the percentage you can increase your regular payment by, and the second represents the percentage of your original loan amount that you can make as a lump sum payment annually.
Let’s look at some examples of how the various prepayment options work.
The payment increase method of your prepayment privilege allows you to increase your regular mortgage payment (monthly, bi-weekly, weekly, etc.) by the percentage amount outlined in the contract.
For example, a 20/20 prepayment privilege would allow you to increase your payment amount by 20% (the first number). This means if you max out your payment increase privilege on a regular mortgage payment of $1,000, you can increase your payment to $1,200 without incurring a prepayment penalty.
The amount you can increase your regular mortgage payment using the payment increase privilege continues to grow by the amount stated in the mortgage contract year-over-year. Below is an example of what your payments would look like over a 5-year term using a payment increase privilege of 20% on a $1,000 regular mortgage payment.
Year 1 – $1,200
Year 2 – $1,400
Year 3 – $1,600
Year 4 – $1,800
Year 5 – $2,000
The above payment increase example simply stacks an additional 20% of the original payment amount each year, but some mortgage lenders will do it differently by increasing the previous month’s payment by another 20% each year. This causes an exponential increase in the amount you can pay. Here’s what it looks like:
Year 1 – $1,200
Year 2 – $1,440
Year 3 – $1,728
Year 4 – $2,073.60
Year 5 – $2.488.32
It’s important to note that the payment increase privilege doesn’t stack automatically. So if you chose not to use the privilege and kept your regular mortgage payment at the original $1,000 for the first three years of the term but wanted to increase it in year 4, the maximum amount you could pay is $1,200 as opposed to the $2,073.60 seen in the last example.
The lump sum prepayment privilege does just what the name suggests. It allows you to put a lump sum payment toward paying off your mortgage’s principal. As mentioned earlier, the second number of the prepayment privilege outlined in the mortgage contract determines the down payment amount. A 15/15 prepayment privilege on a mortgage with a starting balance of $400,000 would allow a lump sum payment of $60,000 per year ($400,000 * 15%).
It’s important to know that not all lenders have the same rules surrounding their lump sum prepayment privilege. Some lenders only allow one lump sum payment to be made per year, while others allow multiple as long as they fall on a regularly scheduled payment date. Some lenders are even more flexible, allowing multiple lump sum payments to be made at any time.
Double Up / Match a payment
Some lenders also provide the option to double up or match your regular mortgage payment on any or every payment date, depending on the lender. Let’s say you have a regular monthly mortgage payment of $2,500; the double up prepayment privilege would allow you to increase your regular payments up to $5,000 – the equivalent of the principal and interest portion
That said, you don’t necessarily need to have the “double up” payment privilege to double your mortgage payments. If your lender allows you to make multiple lump sum payments over the course of the year on the regularly scheduled payment dates, you could simply make a lump sum payment of $2,500 (or more) on the scheduled payment dates to “double up” your mortgage payment.
Not all lenders offer the same benefits
As we’ve outlined throughout the article so far, a mortgage’s benefits can vary from lender to lender. That is why it’s essential that you make your decision on more than just the rate that they are offering. The lowest rate may offer minimal flexibility and charge hefty penalties if you want to renegotiate, refinance, or put more money towards your mortgage loan.
Prepayment privileges also vary between lenders, so you must be aware of what privileges are being offered before signing your mortgage contract.
How a mortgage broker can help
At Pineapple, it’s our job to help ensure you find the best mortgage product to fit your needs. Finding a low rate is, of course, part of that, but there is more to it. Having the flexibility to refinance or renegotiate mid-term, along with the ability to put more money towards your mortgage via better prepayment privileges, can end up saving you much more than a slightly lower rate will in the long run. Our expert mortgage brokers understand this and will work to find you an amazing mortgage that pairs a great rate with all of these other benefits to best fit your needs.