A prepayment privilege is the amount you can put toward a closed mortgage on top of your regular mortgage payments, without having to pay a prepayment penalty.
Your prepayment privileges allow you to:
- increase your regular payment by a certain percentage
- make a lump-sum payment up to a certain amount or percentage of the original mortgage amount
Privileges vary from lender to lender.
Check the terms and conditions of your mortgage contract to find out:
- if your lender allows you to make prepayments
- when your lender allows you to make prepayments
- if there is a minimum or a maximum amount that you may prepay
- what fees or penalties may apply
- other related terms or conditions
If you don’t make a prepayment on your mortgage one year, you usually won’t be able to add the amount you didn’t use to your prepayment the following year.
A prepayment penalty is a fee that your lender may charge if:
- you make more than the allowed additional payments toward your mortgage
- you break your mortgage contract
Your lenders may call the prepayment penalty a prepayment charge or breakage cost.
Prepayment penalties can cost thousands of dollars. It's important to know when they apply and how your lender calculates them.
You can base your estimate of your prepayment penalty on factors such as:
- how much you want to prepay (or pay off early)
- how many months are left until the end of your term
- interest rates
- the method your lender uses to calculate the charge
When prepayment penalties apply
If you have a closed mortgage, you'll need to pay a prepayment penalty if you:
- pay more than the amount your prepayment privileges allow
- borrow more money using home equity
- break your mortgage contract
- transfer your mortgage to another lender before the end of your term
If you have an open mortgage, you can make a prepayment or lump-sum payment without paying a penalty.
How lenders calculate prepayment penalties
The way your prepayment penalty is calculated varies from lender to lender.
The prepayment penalty will usually be the higher of:
- an amount equal to 3 months’ interest on what you still owe
- the interest rate differential (IRD)
The interest rate differential is the difference between the interest rate on your current mortgage term and today’s interest rate for a term that is the same length as the remaining time left on your current term.
Review your mortgage contract to find out exactly how your lender will calculate your prepayment penalty. Check with your lender for the actual amount. Ask your lender to explain anything you don’t understand.
You may also have to pay an administration fee to make a prepayment.
Prepayment penalties on discounted interest rates
If you negotiated a discounted interest rate, the calculation of the interest rate differential will depend on the lender and the terms of your mortgage contract.
To calculate your prepayment penalty, lenders may use:
- the advertised interest rate at the time you signed your mortgage and the current posted rate for your term
- your actual discounted interest rate and apply the discount to the current interest rate
- your discounted interest rate for your current term and the advertised interest rate at the time the calculation is made
Example: Estimate your prepayment penalty
Suppose you want to break your mortgage contract to get a new contract with a lower interest rate. You want to estimate how much the prepayment penalty will be.
Assume the following:
- outstanding mortgage balance: $200,000
- annual interest rate: 6%
- number of months left in term: 36 months (or 3 years) left in a 5-year term
- the current posted interest rate for a mortgage with a 36-month term (term of the same length) offered by your lender: 4%
|Step 1: Identify the outstanding balance on your mortgage.||$200,000|
Step 2: Multiply the outstanding balance on your mortgage by the annual interest rate on your mortgage.
(Write the annual interest rate as a decimal. For example, 6% = 0.06)
|Step 3: Divide the answer by 12 months in a year to get the monthly interest payable.||$12,000
|Step 4: Multiply the answer by 3 months.||$1,000
|Prepayment penalty estimate based on 3 months’ interest:||$3,000|
Calculate your prepayment penalty using the interest rate differential
The following example is a simplified way to estimate the interest rate differential. It's for illustration purposes.
|Step||Example||Enter your information|
|Step 1: Identify the outstanding balance on your mortgage.||$200,000|
|Step 2: Identify the annual interest rate on your mortgage.||6%|
|Step 3: Identify the current interest rate for the term closest to the remaining time left on your current term.||4%|
|Step 4: Subtract the answer found in step 2 from the answer found in step 3 to get the difference in interest rates. (Write this interest rate as a decimal. For example, 2% = 0.02)||6% - 4%
|Step 5: Multiply the answer from step 4 by the outstanding balance on your mortgage in step 1.||0.02
|Step 6: Divide this answer by 12 months in a year to get the monthly interest differential.||$4,000
|Step 7: Multiply this answer by the number of months left on the term.||$333.33
|Prepayment penalty estimate based on interest rate differential (IRD):||$12,000|
Paying your prepayment penalty
Your lender may allow you to add a prepayment penalty to your mortgage balance. This means you’ll pay interest on your prepayment penalty.
You can also pay your prepayment penalty up front.
Tips to reduce or avoid prepayment penalties
Consider the following options to reduce the amount of money you may pay in penalties.
Make full use of your prepayment privileges
Make full use of your prepayment privileges every year. Any future prepayment penalties will be based on a lower mortgage balance.
Make a lump-sum prepayment before you break your mortgage. Although, some lenders will restrict your ability to prepay if you're too close to the date you break your contract.
Read your mortgage contract carefully. Ask questions about anything you don't understand.
Wait until the end of your term to prepay
Consider waiting until the end of your term to prepay if your prepayment penalty will be a large amount. You can then make a lump-sum prepayment without penalty.
Port your mortgage
If you're buying a new home, ask your lender if you can port your mortgage. This means taking your existing interest rate and terms and conditions with you to your new home. It saves you from breaking your mortgage contract and getting a new one
Shop around when you renew your mortgage. Contact various lenders and mortgage brokers to check if there is a better mortgage option that will offer you more flexibility to make prepayments.
Questions to ask your lender about prepayments
When shopping around for a mortgage, look for flexibility in prepayment privileges.
Ask your lender the following questions before signing a mortgage contract:
- how much you can prepay without paying a penalty
- if there's a fee for making a prepayment
- if there's a minimum or maximum amount for a prepayment
- when and how often you can make prepayments
- if there are any conditions related to prepayments
- if you can re-borrow any prepayments you made
What you need to know about prepayment penalties
If a federally regulated financial institution, such as a bank, issues your mortgage, the following details must appear in an information box at the beginning of your mortgage agreement:
- prepayment privileges
- prepayment penalties, that is, prepayment charges
- other key details
Your lender must tell you how they will calculate your prepayment penalty. Your lender must also tell you what factors are used to determine the penalty. These details must be clear, simple and not misleading.
Read your mortgage contract carefully. Make sure you understand the details about penalties before you sign your contract. Ask questions about anything you don't understand.
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