Mortgage Pre-Payment Privileges
This is the 14th article in our Mortgage Life Cycle Costs series.
What do we mean by Mortgage Life Cycle Costs, and why have we written so much about this obscure and seemingly unimportant topic? Isn’t a mortgage just about getting the lowest rate? See the 1st article in this series for a more complete explanation, but briefly stated, Mortgage Life Cycle Costs are additional, non-interest mortgage costs that you could/will incur during your mortgage term. These costs are often indistinct, usually incurred later during the mortgage term, and their severity depends on the lender, loan type, loan terms & conditions, product, interest rate, interest rate type, etc. Mortgage Life Cycle Costs can significantly exceed the comparatively small interest savings of enticing but limiting slightly lower interest rates.
By over-focusing on interest rates at the cost of the rest of the mortgage details, you can incur significant, but potentially avoidable, mortgage life cycle costs.
While we believe lower interest rates are important, we also think that interest rates can distract us from fully investigating other crucial mortgage aspects. Here’s why we think you should search for more than just the interest rate when choosing a mortgage. Canada’s largest banks are a saturated oligopoly. Oligopolists are typically very large and powerful, interdependent businesses that usually don’t risk competing by price [interest rates for mortgages]. Instead, they compete by image, retention, etc. A quick review of banks’ websites should confirm our banks’ oligopolist relationships with each other: interest rates are very similar and widely published, but very little, if any, detail or education is available about the retention power of their specific mortgage products, terms & conditions, etc. Therefore, why over-focus on obvious interest rates if banks’ rates are similar, and rates aren’t their primary way of competing? Shouldn’t we be more concerned about what we are not shown? Wouldn’t we get better mortgages if we asked more questions about proposed mortgage products, their terms & conditions, and potential consequential limitations and costs? We think so, hence we created these articles to draw your attention to mortgage life cycle costs and their potential to limit your future mortgage options and cost you a lot more than the relatively small interest savings of an appealing but limiting lower interest rate mortgage.
What are pre-payment privileges? They are the amount you can pay by choice, in addition to your regular payments, without incurring a pre-payment penalty. Most good prime mortgages allow you two pre-payment privilege options:
- Increase your regular payments.
- Make lump-sum payments.
Note: The mortgage industry usually considers a mortgage’s pre-payment privilege to be the combination of the two above-mentioned components, regular payment increases, and lump-sum payments. However, some lenders often refer to lump-sum payments as “pre-payments”, while maintaining the industry name for regular payment increases.
We will discuss each privilege option separately below.
Let’s first review general, but important pre-payment privilege information:
Variations: Pre-payment privileges vary significantly between lenders and various mortgage products. There is no single or standard lender or mortgage product pre-payment privilege.
Don’t Assume: Check that the lender and its proposed product allow you to make pre-payments; don’t assume anything about your pre-payment privileges.
Terms & Conditions: The devil’s in the details. Check the lender’s and product’s terms & conditions for the details about pre-payment privilege limitations, minimums, maximums, timing, frequency, fees, penalties, payment reductions after increases, etc.
Beyond the Text: Do you understand your pre-payment privileges? There might be more detail to the written text that you should know. To illustrate, let’s investigate examples of a lender’s pre-payment privilege terms:
- Lump-Sum Payments: “You may prepay up to 10% of the original mortgage amount once in every 12-month period starting on the Interest Adjustment Date or the anniversary of that date.”
- Regular Payment Increases: “You may, once in every 12-month period starting on your Interest Adjustment Date or the anniversary of that date, increase your regular payment by an amount up to 10% of the principal and interest portion of your monthly payment amount.”
These two paragraphs don’t fully reflect the application of your pre-payment privilege, so make sure you understand all the details.
Consequences of Pre-payment Privileges: Most Canadian mortgages have blended payments. Assuming all things are equal, simply put, blended payments mean you repay the mortgage with equal payments over the agreed-upon amortization period. As your mortgage progresses towards zero, the regular payment remains the same, but an increasing part of the payment is allocated to the mortgage principal and the decreasing remainder to the mortgage interest.
What happens when you make pre-payments? Here are two of the consequences:
- Reduced Amortization Period: Making any pre-payment privilege payments will make your mortgage-free faster. Pre-payments reduce your remaining mortgage balance and consequently, it’s actual, remaining amortization period, but do not change its regular contract payment.
- Increased Equity: The equity in a property is the difference between the property’s value and the remaining balance of the mortgage registered against it. Therefore, pre-payments will increase your equity in your property.
Pre-payment Withdrawals: Can you withdraw your earlier prepayments from your mortgage in the future? No, not unless your mortgage product allows it, or you refinance into a new mortgage. Re-advanceable mortgage products are not offered by all lenders, are more complex and riskier, and are a major contributor to lingering mortgage debt.
Start & Stop Dates: Prepayment privileges are usually based on an annual period. Each year’s available prepayment privilege usually starts on the mortgage’s anniversary date and ends the day before the next year’s anniversary date. For example, if your mortgage closes on May 1, 2023, your mortgage anniversary date is usually on May 1 of each of the mortgage term years.
Not Cumulative: Prepayment privileges are usually not cumulative from year to year. Whatever prepayment privileges you don’t use this year cannot be transferred or added to the next or any other year’s prepayment privileges.
Aggregate Prepayment Privileges: Depending on the lender and product, you can expect either separate annual maximum limits for each prepayment privilege option or an aggregate for the combination of the two options. For example, lump-sum payments: 15% p.a. | Regular payment increases: 10% p.a. | Aggregate: 15% p.a.
Aggregate usually means neither an individual prepayment option nor the combination of both options may exceed the mortgage’s maximum aggregate prepayment privilege limit.
Exceeding Prepayment Privileges: If you exceed your prepayment privileges, you will incur a mortgage penalty. Penalty terms and conditions, how they are calculated, etc. can vary significantly between lenders, so check your mortgage terms and conditions for details.
Pre-Payment Requests: Lenders usually don’t give clients the ability to make prepayments themselves. They usually require clients to contact their customer service to make those changes. Some lenders allow your broker to request your prepayment changes on your behalf. Read more about customer service and how poor support can cost you money.
In this section, we will discuss an increase in the regular payment as a pre-payment privilege option.
Maximum Increase: To determine the maximum payment increase per mortgage payment per year, multiply the lender’s maximum permissible pre-payment % with the mortgage contractual monthly payment. For example, for a $2,000/month mortgage payment and a maximum payment increase limit of 10% per annum:
- 10% x $2,000 = $200/month. The new, increased mortgage payment should be $2,200/month if you apply the maximum privilege.
Minimum Increase: Lenders usually don’t require a minimum eligibility payment increase.
Payment Increase Frequency: Most lenders allow one payment increase per year.
Payment Decrease Frequency: If eligible, most lenders usually allow one payment decrease per year. Some lenders DISALLOW payment reductions once you’ve increased your payment. This serious limitation is not obvious, or easy to spot, so check your terms & conditions carefully.
Payment Increase Variations: To make their mortgages more attractive, some lenders offer variations of the regular payment increase privilege, such as accelerated bi-weekly or weekly payments. See my article about bi-weekly vs. accelerated bi-weekly payments. Although these variations might automate payment increases, they usually do the same thing as other payment increases.
In this section, we will discuss the lump-sum pre-payment privilege option.
Maximum Lump-sum Payments: To determine the maximum permissible total annual lump-sum payments, multiply the lender’s maximum lump-sum pre-payment % with the original mortgage balance. For example, for a $500,000 mortgage balance and a maximum annual lump-sum limit of 10% p.a.,
- 10% x $500,000 = $50,000 p.a. This means annual lump-sum prepayments must not exceed $50,000 p.a.
Minimum Lump-sum Payments: Lenders usually impose a minimum eligibility lump-sum payment. For example, no less than $100 per lump-sum payment.
Lump-sum Payment Frequency: How often and when you can make lump-sum payments vary significantly between lenders. You should aim for maximum flexibility. Very few but the best mortgages allow you to make lump-sum payments at any time as long as you adhere to the mortgage’s terms & conditions.
Lump-sum Payments as Payment Increases: Very few but the best mortgages allow you to add a regular lump-sum amount to each and every mortgage payment. This means your new mortgage payment will appear to be a payment increase privilege, but without the usual start & stop limitations of the payment increase privilege.
Lump-sum Payment Privilege Variations: To make their mortgages more attractive, some lenders offer variations of the known lump-sum pre-payment privilege. For example, “Double-up Payment.” Once a year, you can double your regular mortgage payment. Although a lender might use a different name for its lump-sum privilege, the additional once-off payment is essentially still a lump-sum privilege.
The mortgage pre-payment privilege can be your most helpful mortgage planning tool. The best and most flexible pre-payment privileges can save you money, limit your risks, and give you flexibility, so pay attention and make sure you secure suitable pre-payment privileges.
Here are some ways your pre-payment privilege can help you plan your mortgage: [Assuming all things are equal]
- Flexibility: As I described above, look for a mortgage that allows you to use the lump-sum privilege to make payment increases. This will give you desirable flexibility.
- Risk Planning: If you can afford your mortgage but are concerned about future cash flow or budgeting issues, you could request a mortgage with a higher amortization period [lower mandatory payment] and then voluntarily increase your mortgage payment [reduce your amortization period] to your desirable payment after the mortgage closing date. Then, when you later need to reduce your mortgage payments to the contractual amortization until you are ready to increase the payment again.
- E.g. You hope to pay your mortgage off in 20 years, but you’re planning to start a business in a few years. During the early years of your business, you might want reduced payments. To minimize the cash flow risk, you could ask your mortgage broker to approve your mortgage at a 25-year amortization period and then voluntarily increase your mortgage payment to the equivalent 20-year amortization payment after the closing date. This gives you the flexibility to reduce your mortgage payment and protect your finances if you wish to, but if you don’t, you can maintain your increased mortgage payment and pay your mortgage off in 20 years.
I hope you learned something from this article. Pay close attention to your mortgage pre-payment privilege; it could save you financially and help you pay off your mortgage quicker. Involve your mortgage broker in your mortgage pre-payment plans, and with the right mortgage, they can help you navigate the pre-payment privilege nuances.
- The author is not a lawyer, accountant, financial planner, etc. therefore the author is not providing any professional advice, beyond that of a licensed Mortgage Broker in the province of Ontario, Canada.
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