Mortgage Pre-Payment Privileges 101

Photo Credit: Globe and Mail

When shopping for a mortgage a lot of first-time homebuyers make the mistake of only looking for the lowest mortgage rate. Although your mortgage rate is very important, pre-payment privileges can be just as important, especially if you plan to pay off your mortgage a lot sooner.
Homebuyers have the choice between two types of mortgages – open and closed. Most homebuyers go with closed mortgages. With open mortgages although you can pay off your mortgage in full at any time, you’ll pay a higher rate for this privilege. With closed mortgages you’ll pay a hefty penalty – the greater of the Interest Rate Differential (IRD) or three months’ interest – if you pay off your mortgage in full early. However, there’s a silver lining – you often receive pre-payment privileges that allow you to pay off a portion of your mortgage without penalty. Let’s look at the three most common pre-payment privileges so you can be mortgage-free years sooner.

Payment Increase
According to the Canadian Association of Accredited Mortgage Professionals (CAAMP), payment increases are the most popular pre-payment privilege homeowners take advantage of. 16 per cent of homeowners increased their payment in 2012. If you have a closed mortgage, most lenders allow you to increase your mortgage payment by 10 to 20 per cent once a year. This is a great way to pay down your mortgage years sooner – while regular mortgage payments go towards principal and interest, your increased payment goes straight to principal. For example, if your monthly mortgage is $1,200 and your lender allows you to increase your payment by 20 per cent, you could bump up your payment to $1,440 and pay an extra $240 towards principal.

Lump Sum Payment
According to CAAMP, lump sum payments are the second most popular way homeowners pay off their mortgage sooner. 15 per cent of homeowners made lump sum payments in 2012. Lump sum payments are probably what you think of first when you hear “pre-payment privileges.” Mortgage lenders often let you pay between 10 and 20 per cent of your mortgage as a lump sum in a year. You’re probably thinking I don’t have an extra $40,000 kicking around to pay towards my mortgage. The good news is you don’t have to make the lump sum payment all at once – you can stagger smaller amounts throughout the year with your regular mortgage payments. If you have a mortgage of $400,000 with a 20 per cent pre-payment privilege, you can pre-pay up to $80,000 in a year. Lenders often have a minimum pre-payment amount such as $100. Even if you can only afford to pay an extra $100 a month towards your mortgage it can mean years off your mortgage and thousands saved in interest over the life if your mortgage.

For example, if you have a mortgage of $340,000 at a five-year fixed rate of 2.74 per cent, your monthly mortgage payments would be $1,564 amortized over 25 years. By increasing your mortgage payment by $200 per month you’ll only pay $107,685 in interest over the life of your mortgage versus $129,206 without pre-paying, a savings of $21,521 in interest.

Increase Payment Frequency
According to CAAMP, only 6 per cent of homeowners increased their payment frequency. Most homeowners pay their mortgage monthly, but that’s not your only choice. Lenders often allow you to pay your mortgage more frequently, including bi-weekly and weekly. Instead of paying $1,200 per month you can choose to pay $600 bi-weekly or $300 weekly. Although you’re still paying the same amount, by paying sooner rather than later you’ll save thousands in interest over the life of your mortgage. If you’re really keen on paying off your mortgage sooner you can choose weekly or bi-weekly accelerated – you’ll make an extra two payments a year which will go straight to principal.