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Mortgage prepayment is often overlooked but is a vital tool for paying off your mortgage in less time and at a lower cost.
It is an option offered by mortgage lenders to help you pay your mortgage faster, allowing you to save on future interest.
This guide explains everything you need to know about mortgage prepayment, navigate the prepayment process, avoid penalties penalized, and when is best to use it.
Mortgage prepayment is an option for homeowners who wish to pay off their mortgage loan faster than the agreed-upon timeline.
It involves making additional payments to your mortgage than required. Prepaying your mortgage will help you reduce how much you’ll spend on interest costs over the life of the loan.
Mortgage prepayment as a strategy to pay off your mortgage fast can also be helpful when it comes to achieving specific financial goals, such as building equity more quickly or becoming debt-free before retirement.
It is advisable to review your mortgage commitment letter and its accompanying disclosures to ensure you understand any restrictions, penalties or fees associated with early repayment.
Generally, lenders allow homeowners to make one-time lump sum payments or extra payments directly to the loan principal without penalty.
You can pay down your mortgage faster using one of the following tactics;
A percentage increase of your regular payment
For example, if your regular mortgage payment is $1,500, you can ask to increase this payment by 30%, raising each payment to $1,950.
A lump-sum payment towards your mortgage principal once a year.
You can make a one-time lump sum payment of 10% to 20% of the original loan amount.
Even though Prepaying a mortgage can be a strategic move for borrowers interested in reducing their interest expenses, there are a few things to consider before taking this action;
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As an amortized loan, a mortgage is designed to be paid off over a long period, usually 25 to 30 years.
The loan is paid gradually at regular intervals, monthly, bi-weekly, semi-monthly or weekly. Each payment comprises the loan’s principal and the accrued interest.
The accrued interest portion of your payment is revenue to the lender. At the same time, the principal amount is what goes to pay down the loan. The interest is the charge of lending you the mortgage loan.
The interest is calculated on the loan balance owed. Paying down the loan fast reduces the outstanding balance, the future interest expense, and the lender’s potential revenue.
As an example, the following table shows the impact when a loan balance is reduced from $100,000 to $80,00:
| Loan Balance | Interest Rate | Calculation | Annual Accrued Interest (Lender’s Revenue) |
High Loan Balance | $100,000 | 2.5% | $100,000 x 0.025 | $2,500 |
Low Loan Balance | $80,000 | 2.5% | $80,000 x 0.025 | $2,000 |
As the above table illustrates, the lender’s revenue decreases from $2,500 to $2,000 as the outstanding loan balance decreases from $100,000 to $80,000.
This decrease in profit explains why lenders won’t want you to pay down or off your mortgage fast.
Mortgage lenders make more money if you pay your mortgage as scheduled throughout the term.
You will incur prepayment charges if you do any of the following:
Prepaying your mortgage balance helps reduce the interest you pay over the loan term while also paying it off faster.
Prepayment is an excellent option to consider if the following apply to you:
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Different types of mortgages have different types of prepayment conditions attached to them. You must know the basic prepayment conditions included in your mortgage.
Selecting a mortgage without considering its prepayment terms can cost you thousands in penalties.
Open-term mortgages have no prepayment restriction; you can prepay all or part of an open-term mortgage anytime during the term. This mortgage type has the most flexible prepayment structure.
However, the unrestricted prepayment advantage of open-term mortgages comes at the cost of high mortgage rates. The mortgage rates of open-term mortgages are higher than comparable closed-term mortgages.
Closed-term mortgages cannot be renegotiated, prepaid, or refinanced before the end of the term without prepayment charges. However, most closed mortgages have prepayment privileges, allowing you to prepay 10% to 20% of the mortgage balance each year.
Overall, the main advantage of closed-term mortgages is their lower mortgage rates than open-term ones.
Learn More About Closed-Term and Open-Term Mortgages
A variable-rate mortgage is where the interest rate changes over time, usually based on a predetermined index.
Mortgages with variable interest rates can help you take advantage of changing or fluctuating interest rates.
The prepayment penalty calculation for closed-term variable-rate mortgages is straightforward and simple.
The penalty is the three-months interest expense.
[(Mortgage Rate/12) x Mortgage Balance) x 3] = Penalty
The prepayment penalty on variable-rate mortgages is lower than penalties on comparable fixed-rate mortgages. With the low prepayment charges, variable-rate mortgages could be the better option if you expect to make a larger payment to your mortgage before the end of the term.
Learn More How Variable-Rate Mortgages Work In Canada
A fixed-rate mortgage is a type of mortgage whose interest rate remains the same for the entire loan term. This type of mortgage is popular among people who want to lock in their interest rates and have less variability in their monthly payments.
The prepayment penalty charge for a fixed-rate mortgage is usually higher than for a comparable variable-rate mortgage. Also, the prepayment calculation of fixed-rate mortgages can be a little complex.
Overall, this type of mortgage is a better option for people who want to lock in their interest for the entire term and prefer predictable monthly expenses.
Learn More: How Fixed-Rate Mortgages Work In Canada.
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As explained above, your mortgage prepayment depends on your mortgage type. Let’s explore the breakdown of the calculations involved in mortgage prepayment and the eventual charges.
The prepayment penalty for a variable-rate closed mortgage is the three-month interest charge over your prepayment privilege.
For example, imagine your prepayment privilege only allows you to pay a maximum of $15,000 to your mortgage, but you want to pay $25,000. Your prepayment charge will only be calculated on $10,000, the difference between your prepayment privilege and your actual payment.
For a fixed-rate mortgage, the prepayment penalty amount is the greater of the following:
The three-month interest charge of the amount prepaid (just like with a variable-rate mortgage)
OR
The interest for the remainder of the term on the amount prepaid is calculated using the Interest Rate Differential (IRD)
The interest rate differential is the difference between your mortgage interest rate and the current posted rate for a similar mortgage.
By “similar”, I mean;
Step 1: Estimate the interest charge for the remaining term of your mortgage using your mortgage interest rate and any rate discount you were offered.
Step 2: Calculate the interest over the remaining term of your mortgage using the lender’s posted interest rate for a mortgage with a term and prepayment options similar to your mortgage.
Step 3: Compare the results of the above two calculations. The prepayment charge is the higher amount of the above two calculations.
The prepayment charge will be calculated on the entire mortgage balance if you pay off all the mortgage loans, which is common when refinancing or selling your house.
But if you are paying just a portion of your mortgage balance, the prepayment charge will be calculated only on the amount paid that is over the prepayment privilege of the loan.
Imagine you are considering refinancing your closed-term mortgage. The mortgage has the following attributes:
Your lender’s current prime rate is 3.2%
Note that your mortgage’s entire $250,000 balance will be paid off since you are refinancing the mortgage. The following is how your prepayment penalty will be calculated:
Step 1: Your current mortgage balance = $250,000
Step 2: The lender’s prime rate on the date the discharged documents are prepared is 3.20% = 0.032
Step 3: Annual Interest Amount Calculation
Multiply the prepayment amount by the interest rate to calculate the annual interest expense:
$250,000 x 0.032 = $8,000
Step 4: Monthly Interest Amount Calculation
Convert the above calculated annual interest amount to the equivalent monthly interest payments by dividing it by 12:
$7,000 / 12 = $666.67
Step 5: 3-Month Prepayment Penalty Charge Calculation
Multiply the monthly interest amount by 3:
$666.67 x 3 = $2,000
The lender will charge you an estimated $2,000 if you choose to pay out the mortgage loan.
Imagine a fixed-rate mortgage with the following attributes:
The lender’s current posted rate for a similar 2-year term mortgage is 4.20%
Given that your mortgage term is closed and your interest rate is fixed, your prepayment charge will be the greater of the following:
Step 1: The amount to pay out = $250,000
Step 2: The interest rate = 3.10% (your mortgage rate of 2.50% plus the 0.60% discount you received, which is equal to 3.10%) = 0.031
Step 3: Annual Interest Amount Calculation
Multiply the prepayment amount by the interest rate to calculate the annual interest expense:
$250,000 x 0.031 = $7,750
Step 4: Monthly Interest Amount Calculation
Convert the above calculated annual interest amount to the monthly interest payments by dividing it by 12:
$7,750 / 12 = $645.83
Step 5: Calculate the 3-Month Prepayment Penalty Charge Calculation.
Multiply the monthly interest amount by 3: $645.83 x 3 = $1,937.50
The 3-months interest charge will be $1,937.50.
Step 1: Using a mortgage calculator, the total interest expense that you will incur if you have to stay in the mortgage contract for the remaining 2 years term will be $13,768.08
You add the interest expense for Years 4 and 5:
$7,000.12 + $6,767.96 = $13,768.08
Step 2: The lender’s comparable posted 2-year fixed-rate closed mortgage rate: 4.20%
Step 3: Using a mortgage calculator, the total interest expense of a similar mortgage at the lender’s current posted 2-year rate of 4.20% is \$20,531.75
You add the interest expense for Years 1 and 2:
$10,389.60 + $10,142.15 = $20,531.75
Step 4: Interest rate differential of the two rates:
The interest calculated in Step 3 is subtracted from the interest set out in Step 1. This is the interest rate differential amount: $20,531.75 – $13,768.08 = $6,763.67
The estimated prepayment charge using the interest rate differential is $6,763.67, the higher amount of the above two methods (IRD and 3-month interest charge).
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A cashback mortgage is a type of mortgage program with a lump sum cash incentive of 1% to 5% of the loan amount when the mortgage closes. Some lenders may require you to pay back part or all of this cash incentive when you do any of the following:
You will also pay the discharge fee when you prepay your mortgage. The discharge fee is paid for preparing and registering the legal documents required to release the lender’s collateral hold on your house when you pay off a mortgage.
A mortgage assignment transfers mortgage ownership from one lender to another.
The assignment charge fee is usually between $25 and $330 and is typical when switching your mortgage lenders.
In general, your prepayment penalty will depend on the following factors:
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