Mortgage Basics

Understanding Pros And Cons of Mortgage Prepayment Privileges

Understanding Pros And Cons of Mortgage Prepayment Privileges
Written by
  • Ashley Howard
| 11 September 2023
Reviewed, 18 September 2023

Table of contents

    When purchasing a home, you will likely rely on a mortgage to cover the cost. Taking on a mortgage is a significant long-term financial commitment that could take a few decades to complete. While that may sound like an eternity, there is a way you can pay off your mortgage faster and save thousands of dollars in interest in the process. 

    This article will explore mortgage prepayment privileges, how they work, and weigh the pros and cons of using this option. Read on to see how you may be able to take advantage of prepayment privileges on your mortgage to save money and pay it off sooner.

    Key Takeaways

    • Prepayment privileges allow you to make extra payments toward the principal of your mortgage balance.
    • Mortgage prepayments are an easy way to pay down your mortgage, saving you time and money.
    • Each lender will have different prepayment privilege criteria that may restrict how you can utilize this feature.

    What Are Prepayment Privileges?

    Prepayment privileges are conditions in your mortgage contract that allow you to make extra payments in addition to your regular mortgage payment without incurring prepayment penalties. These privileges provide you with the flexibility to accelerate your mortgage payments and reduce the total interest charged over the life of your mortgage. 

    Depending on your lender and the conditions of your specific mortgage, you can leverage prepayment privileges in several ways. It’s important to note that whichever option or combination of options you choose cannot exceed the total prepayment privilege, which is limited to 10%, 15%, or 20%, depending on your lender and mortgage contract. 

    Lump-Sum Payments

    A lump-sum payment is one of the most common ways to take advantage of prepayment privileges. Some mortgages will allow you to only make one lump-sum payment each year on your anniversary date. Others will allow you to make one prepayment a year at any time during the calendar year or as many prepayments as you wish throughout the year as long as it’s within your annual prepayment limit.

    Increased Payment Amount

    Another option is to increase your mortgage payments. You can increase your payments up to the allowable limit once a year on the anniversary date or once at any time during the year, depending on your lender. 

    Double Up Payments

    Double up payments allow you the option of paying double or making two mortgage payments on the same date. Anything beyond your scheduled payment will go directly toward the principal balance of your mortgage. 

    Increased Payment Frequency

    You may accelerate your payments instead of traditional monthly or bi-weekly payments. Options such as accelerated bi-weekly or even accelerated weekly will increase the amount going toward your principal each year. Not all lenders offer accelerated payment schedules, and some will only allow you to change your payment frequency once per year. 

    The Advantages of Prepayment Privileges

    Utilizing prepayment privileges can provide several benefits, giving you more control over your financial situation and helping you achieve your goals faster. Here are some advantages that prepayment privileges offer:

    • Save interest: Every additional amount you put towards your mortgage goes directly toward the principal, meaning you’ll pay less in interest. Over time, the more you exercise your prepayment privileges, these savings can accumulate substantially, allowing you to pay off your mortgage sooner and reduce the overall interest-carrying cost of borrowing.
    • Pay off your mortgage faster: Any amount of prepayment means you are paying off your mortgage faster. This can be particularly appealing if your goal is to be mortgage-free sooner. Paying off your mortgage sooner not only provides a sense of financial security but also frees up cash flow for other goals and expenses.
    • Prepayment Flexibility: Depending on your lender, prepayment privileges provide you with the flexibility to make additional payments to your mortgage to match your changing financial circumstances. If you receive a yearly bonus or a one-time inheritance, you can make a lump-sum payment or increase your mortgage payments with the extra money you have available. Additionally, increasing your regular payment amount as your income grows over time allows you to pay down your mortgage in a way that aligns with your financial circumstances.

    Cons of Prepayment Privileges 

    It’s important to be aware of the potential limitations that may apply to prepayment privileges on your mortgage. Before making any prepayments, it’s crucial to read through your mortgage contract or reach out to your lender to better understand what penalties may be associated with your mortgage. Here are some cons to utilizing your prepayment privileges: 

    • Lender limitations: Lenders often impose limits on the amount you can prepay each year, usually 10%, 15% or 20% of your original mortgage amount. If you exceed these limits, you may face prepayment penalties. 
    • Prepayment penalty: If you exceed your mortgage prepayment privileges, your lender will likely charge a prepayment penalty. These penalties could be much higher with fixed-rate mortgages since you are likely to pay the interest rate differential (IRD) compared with only 3 months’ interest on variable-rate mortgages. 
    • Diversification risk: While making extra payments on your mortgage can save you money in the long run, it’s important to consider how these payments may impact your other financial goals. Allocating additional funds towards your mortgage may limit your ability to invest, save for retirement, or build an emergency fund. Ensure that prepaying your mortgage aligns with your overall financial strategy and priorities.
    • Liquidity risk: When you prepay your mortgage, the money becomes tied up in your home’s equity and is not easily accessible. Refinancing a mortgage is always more expensive than financing one, so it may be more complex and costly if you need to access the equity in your home in the future. In case of financial emergencies or unexpected expenses, having cash or investments readily available may be more beneficial.
    • Currency Risk: Homes can only be bought and sold in Canadian dollars, and mortgages can only be arranged in Canadian dollars. On the other hand, investments may be diversified in multiple currencies, hedging risk.

    Before Anything Else, Review Prepayment Privileges 

    When shopping for a mortgage, it’s important to evaluate the prepayment privileges offered by different lenders. Understanding the terms and conditions associated with prepayment privileges can help you choose the right mortgage for your needs. Consider the following during your evaluation of your mortgage contract terms:

    Assess Prepayment Terms

    Not all mortgage lenders offer the same prepayment privileges. Some may allow you to pay a larger percentage per year, others may come with restrictions on how often you can make prepayments, and some will even restrict you to only making prepayments once a year on your mortgage anniversary date. Reviewing and comparing all terms and conditions to determine which privileges best align with your financial goals and personal preferences is essential.

    Consider Your Financial Goals

    Before deciding to utilize prepayment privileges, consider your overall financial goals and objectives. If you anticipate having extra funds you’d like to put towards your mortgage, prepayment privileges would be a valuable feature. However, ensure that prepaying your mortgage does not hinder your ability to pursue other important financial goals, such as investments and saving for retirement.

    Seek Professional Advice

    A mortgage expert can provide valuable guidance throughout the mortgage process. They can help you understand the terms of your mortgage and advise on how best to utilize your prepayment privileges based on your financial situation and future goals. Consulting with a professional can ensure you optimize prepayment privilege benefits.

    Here Are Some Ways Prepayment Privileges Look In The Real World

    Now that we’ve explored the concept of prepayments let’s see how they work in real life and their potential impact.

    Let’s explore how prepayment privileges could help save you money if you initially took out a $500,000 mortgage with an interest rate of 5.29% and a 25-year amortization. Your lender allows a 20% prepayment privilege, and you have been making monthly payments of $2,991 for the past 2 years. You have never used your prepayment privileges and have a remaining mortgage balance of $479,500. 

    Lump sum payment:

    You received an inheritance of $100,000 and want to put half toward your mortgage and invest the other half. Since your prepayment privileges allow you to pay up to 20%, $50,000 is within your limit so you won’t incur prepayment penalties. 

    $500,000 x 20% = $100,000

    Putting an additional $50,000 on your mortgage goes directly to paying down the principal. You would immediately reduce your mortgage balance from $479,500 to $429,500. In this scenario, paying off $50,000 of your principal allows you to pay off your mortgage faster by a little over 4 years, and over the life of the mortgage, you will save around $106,000 in interest. 

    Increased payment amount:

    You received a raise at work and now have an additional $1,000 a month in your budget that you’d like to allocate to your mortgage. You increase your monthly mortgage payment from $2,991 to $3,991. 

    This means you will pay an additional $12,000 a year toward the principal portion of your mortgage, which is well within your prepayment limit. If you maintain this payment for the life of your mortgage, you will reduce your amortization by a little over 9 years, and you will realize savings of approximately $159,500 on the interest-carrying costs of your mortgage. 

    Accelerated payment option:

    You reassessed your budget and realized you have some extra money each month that could be used to put a bit more toward your mortgage. You’ve assessed your prepayment options and have decided that changing from monthly to an accelerated bi-weekly payment schedule would help you pay off your mortgage faster without noticing any impact on your cash flow. 

    Changing your mortgage from a monthly payment of $2,991 to an accelerated bi-weekly payment of $1,495 means you will pay an additional $2,978 per year toward your principal. By choosing an accelerated payment schedule, you reduce your amortization by close to 4 years and realize savings of approximately $67,000 in interest. 

    Frequently Asked Questions

    What is a prepayment penalty, and how can I avoid it?

    A prepayment penalty is a penalty that is charged if you exceed your prepayment limit outlined in your mortgage contract. The penalty will either be the higher of an interest rate differential (IRD) or 3 months of interest, depending on the type of mortgage. This penalty applies at any point if you pay off your remaining mortgage balance either fully or partially before the end of your mortgage term.

    Why should I pay off my mortgage faster?

    The main benefit of paying off your mortgage faster is the amount you will save in interest-carrying costs. In a higher interest rate environment, this can add up to significant savings over the life of the mortgage. 

    Is it better to prepay my mortgage or invest?

    When determining how to utilize extra cash, it’s important to look at how much you can save in interest costs by paying off some of your mortgage balance compared to how much you could earn by investing. 

    Additionally, if you prepay your mortgage, you build equity, though if you need to use that money, you will need to refinance, and it may cost you more in the long run compared to the returns you can earn from investing.

    Final Thoughts

    Prepayment privileges have the potential to save you thousands of dollars in interest and help you achieve mortgage freedom sooner. However, it’s important to consider the potential penalties and limitations that may be associated with making prepayments on your mortgage. 

    Evaluate your financial circumstances, goals, and priorities before deciding on a prepayment strategy. Remember, each lender will have a different prepayment privilege criteria that may restrict how you can utilize this feature to pay down your mortgage. It’s important to speak with a qualified mortgage professional and review any mortgage contract carefully to understand the features and benefits. Ready to get started? Learn how you can compare and save today.