A mortgage prepayment allows you to pay more than your regular mortgage payments, with these extra payments going directly toward reducing the principal of the loan. This can significantly decrease the total amount of interest you pay over the life of your mortgage.
While paying down your mortgage can provide a sense of financial security by reducing your debt, investing the money might offer higher returns, depending on economic conditions. Each option has risks and benefits, making it essential to assess your financial situation and long-term goals before making a decision on whether to make a prepayment.
Key Takeaways
- Mortgage prepayments are extra payments on your mortgage. This money goes directly to the principal of your loan – reducing your balance, saving you interest over time, and potentially shortening the overall term.
- Generally, open mortgages allow you to make prepayments anytime, without penalty.
- Closed mortgages have prepayment limits, which give you the option to pay an extra 10% to 20% towards the principal each year.
- Avoid prepayment penalties by adhering to the terms of your mortgage agreement, taking advantage of prepayment privileges, and waiting until the end of the term to make a large payment.
What is a mortgage prepayment?
A mortgage prepayment is when you choose to pay more money towards your mortgage than your regular monthly payment. This extra money goes directly towards the balance of your loan. By paying down this balance faster, you decrease the total interest you'll pay over the course of your mortgage.
Not all mortgages are the same, and some come with specific rules about how much extra you can pay and when. These rules are part of your mortgage agreement, and it's important to understand them because there might be penalties for paying too much too quickly. Usually, these rules allow you to pay a certain percentage of your original loan amount each year without any extra cost.
| Type of mortgage | Prepayment rules |
|---|---|
| Open mortgage | * Can typically prepay a portion or all of your mortgage at any time, without charge |
| Closed mortgage | * You can prepay according to your privileges – typically 10% to 20% per year * If you pay more than you’re allowed, you can face prepayment penalties |
Prepayments in open mortgages
Open mortgages offer a high level of flexibility when it comes to making prepayments. With an open mortgage, you can pay off your mortgage faster without facing penalties.
This flexibility is helpful for those who:
- Expect their financial situation to change due to factors like selling a property.
- Come into extra money, like a bonus from work or an inheritance.
- Plan to pay the loan off quickly.
Open mortgages typically have 1% - 2% higher interest rates, so before you choose the option, it’s important to consider how long you plan to hold your mortgage. If you think you'll pay it off very quickly, the freedom to make large prepayments without penalties might save you more money in the long run, despite the higher rate.
Prepayments in closed mortgages
Closed mortgages are more restrictive than open mortgages when it comes to prepayments, but most still offer some flexibility. With a closed mortgage, you can typically prepay a certain percentage of the original loan amount each year without facing a penalty – often around 10% to 20%.
Despite these prepayment privileges, if you decide to pay more than the allowed percentage, you might face prepayment penalties. This is because lenders expect to earn a certain amount of interest over the life of the mortgage, and paying it off early disrupts their plans.
How much you can save with a mortgage prepayment
Calculating how much you can save by making mortgage prepayments can be very helpful in planning your finances.
Here’s an example:
Let’s say you have a 5-year closed mortgage of $300,000, amortized over 25 years at a 3% interest rate.
- Initial mortgage amount: $300,000
- Interest rate: 3%
- Amortization period: 25 years
- Regular monthly payment: Approximately $1,420
- Annual prepayment option: 10% of the original mortgage amount
You decide to make a lump sum prepayment of 10% of the original mortgage amount annually.
Here’s what happens:
- Reduction in principal: Maxing out the prepayments directly reduces your mortgage principal by $30,000 each year for a total of $150,000 over 5 years.
- Interest savings: With each reduction in principal, the interest calculated on the remaining amount decreases. In this example, you’d save $89,501.72 in interest.
- New amortization period: Initially 25 years, your amortization period would drop significantly, allowing you to pay off your mortgage much sooner – in this case, 11 years instead of 25.
Using your prepayment privileges could save you tens of thousands of dollars in interest over the life of the mortgage and you would pay off your mortgage 14 years sooner.
To calculate your own prepayment plan, check out the Government of Canada’s Mortgage Calculator.
How to avoid a prepayment penalty
A mortgage prepayment penalty is charged when you pay more than you’re allowed or you refinance or transfer your mortgage before your term is up.
Here are some effective ways to avoid prepayment penalties and pay your mortgage off faster:
- Know your prepayment privileges: Your mortgage might allow you to pay a certain percentage of the original or current balance each year without penalty. This is often around 10% to 20%. Before making any extra payments, check your mortgage agreement to understand the specific terms.
- Increase your payments when possible: If your mortgage terms allow, increase your regular payment amount. Many mortgages let you increase your payment by a certain percentage each year. This extra amount directly reduces your principal faster without incurring penalties.
- Take advantage of payment frequency options: Switching from monthly to accelerated bi-weekly payments can also reduce your principal quicker and save on interest without penalties.
- Stay within your limits: Always make sure that the total of your increased payments and lump-sum payments doesn’t exceed the allowed annual maximum. Staying within these limits ensures you avoid the costly fees associated with breaking your mortgage terms.
- Port your mortgage: If you’re buying a home before your existing term is over, see if you can transfer your current mortgage contract to your new home. This way, you don’t have to worry about paying any penalties from breaking your agreement.
Pros and cons of mortgage prepayments
Here's a simple table showing the good and bad sides of paying off your mortgage early. This will help you decide if it's the right choice for you:
| Pros | Cons |
|---|---|
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FAQ
Can I prepay my mortgage?
Yes, you can prepay your mortgage to reduce your debt faster and reduce the amount of interest you'll pay over time. However, it's important to check your loan agreement for any prepayment limits or penalties to avoid unexpected costs.
How does mortgage prepayment work?
Mortgage prepayments are additional lump sum payments made by a mortgage holder, which are applied directly to the principal of the loan, quickly reducing the balance, shortening the amortization period, and reducing the amount of interest paid over time.
Does prepaying mortgage reduce interest?
Prepaying your mortgage reduces the amount of interest you pay. By paying extra towards the principal, you decrease the loan balance faster, which lowers the total interest charged over the life of the loan.
How much can I prepay on a mortgage?
Each lender and mortgage is different, which is why the amount you can prepay on a mortgage varies. Open mortgages often allow unlimited prepayments without penalties, while closed mortgages typically limit prepayments to about 10 - 20% of the loan per year.
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