What Are Prepayment Privileges?
Becoming a home-owner in Canada is an amazing achievement in its own, but unfortunately the responsibilities don’t end there. Managing a mortgage can be complex, although with the right strategy and utilizing skills like prepayment privileges, you can take control of your mortgage journey and make the most of it.
Understanding Principal and Interest
To fully understand how prepayments benefits your mortgage journey, it’s important to understand that your mortgage is comprised of principal and interest. Your principal is the original loan amount that you used to pay for your house and your interest is the cost you are paying to borrow the money.
So, what are prepayment privileges?
Each mortgage payment (whether it’s monthly, bi-weekly, or weekly) has a portion that goes toward reducing your principal and a portion that pays the interest. When we talk about prepayment privileges, this is referring to separate payments from your regular scheduled payments that entirely goes toward decreasing your principal balance. This payment is in addition to your regular payments.
Why? Because this will reduce the amount of interest you will need to pay over time. Look at it this way, the amount of your prepayment is money from your principal that you don’t need to pay interest on.
Four Ways to Use Prepayment Privileges
1. Lump Sum Payments
With lump sum payments you can contribute fixed amounts or percentages of your principal mortgage amount, depending on the terms set in your mortgage agreement. These additional payments are designed to shrink your original mortgage amount, ultimately leading to lower interest payments over the life of the loan.
Lump sum payments can be executed in four ways:
Before your mortgage term ends.
At the end of your term.
On specific dates outlined in your contract.
During specific times throughout your mortgage term.
Here's a markdown table showing the prepayment difference for a mortgage of $500,000 at an interest rate of 5.54% and 25 year amortization, compounded semi-annually, using different lump-sum payment options. Please note we will use this scenario throughout the blog.
*Disclaimer below
In this table, the "None" row represents the scenario where no additional annual lump sum payments are made. The subsequent rows show the impact of making annual lump sum payments of $1,000, $2,500, and $5,000 at the end of each year, respectively. As you can see, making these lump sum payments accelerate the mortgage payoff time and results in significant interest savings.
2. Increasing Regular Payments
Another form of prepayment can be increasing your regular payments. If you find yourself in a position to comfortably increase your regular mortgage payments, this strategy can pay off immensely. Be sure to discuss this option with your mortgage professional to ensure there is nothing in your mortgage commitment preventing you from using this option. This acceleration can significantly expedite your journey towards a mortgage-free life and reduce the total interest you pay.
*Disclaimer below
In this comparison, the "Standard Monthly" payment type refers to the regular monthly payment without any extra payments. On the other hand, the "Rounded-Up Monthly" payment type involves rounding up the standard monthly payment to the nearest hundred and making that rounded-up amount the monthly payment (+$36.39/m). This approach results in paying off the mortgage faster and saving significantly on interest payments ($12,026) over the life of the loan.
3. Double-Up Payments
This does not mean that you double your mortgage payments every schedule. Double-up payments allow you to make an additional payment equivalent to your regular mortgage payment. While not all lenders offer this option, some provide the opportunity once a year. This can be particularly advantageous if you receive bonuses, pay raises, or any extra income on a regular basis.
*Disclaimer below
In this table, the "Standard Monthly" payment type refers to the regular monthly payment ($3,063.61) without any extra payments. The "Doubled-Up Payment” payment represents a scenario where a doubled-up payment (total of $6,127.22) is made for every payment. Both the "Standard Monthly" and "Doubled-Up Payment" scenarios have different monthly payment amounts, with the latter strategy drastically reducing the interest paid and shortening the mortgage payoff time by more than 16 years sooner.
4. Accelerated Payment Options
Often homeowners are unaware of the variety of payment period available to them. Instead of making monthly payments, you can opt to make payments weekly or bi-weekly. This might sound simple, but it's a powerful method to chip away at your mortgage paying it off 2 to 3 years sooner. By the end of the year, you'll have essentially made an extra monthly payment, effectively reducing both your principal and interest payments.
*Disclaimer below
Please note that these calculations are based on the provided mortgage amount, interest rate, compounding frequency, and different payment options. The "Standard" payment type refers to regular payments without any prepayments, while the "Accelerated" payment type includes additional payments equivalent to one extra payment per year.
Potential Pitfalls
It’s important to consult your mortgage professional when it comes to potential prepayment pitfalls. Prepaying can be an amazing tool, although different lenders have different regulations around this strategy. Some lenders will charge a penalty fee for prepayments which would be outlined in your mortgage commitment. If prepayment privileges is a tool you plan on utilizing, be sure to tell your mortgage broker to ensure the product you are receiving allows for this.
Remember, to make the most of pre-payment privileges, you should:
Understand the terms and conditions associated with your specific lender.
Consider any potential penalties and restrictions.
Calculate the impact of extra payments on your overall mortgage.
Conclusion: A Path to Financial Security
In todays real estate market, mortgage pre-payment privileges are a potent tool for securing long-term financial freedom. By making smart use of these privileges, you're not only investing in your home but also taking charge of your financial future. So, whether you're a seasoned homeowner or just stepping into the realm of property ownership, remember that with the right approach, pre-payment privileges can pave the way for a brighter, debt-free future. Your mortgage isn't just a monthly payment; it's an opportunity to shape your financial destiny.
*Disclaimer: Please note that these calculations are approximate and based on the provided mortgage amount, interest rate, and compounding frequency. The actual savings and payoff times may vary based on the specific terms of your mortgage agreement. It's always a good idea to consult with your lender or a financial advisor to understand how making rounded-up payments could benefit your unique situation. Rates are subject to change without notice. The purposes of this article is for illustrative purposes only. This is not a commitment to lend, pre-approval or approval.