Prepayment Privileges–What You Need To Know
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A mortgage is a considerable financial investment for anyone. It is likely one of the biggest investments an individual will make in their lifetime and there are many aspects to consider to ensure that your type of mortgage is the right one for you. A large part of the decision will be based on your personal situation (how much down payment you have, do you have a stable income, is your employment seasonal, what is your debt to income ratio, do you need more flexibility with monthly payments or do you want to lock in and speed up the payments for the term, etc).
With so many things to consider, surrounding such a large financial commitment, it's a smart idea to do your research and talk to a mortgage specialist. There might be elements of a mortgage you might not consider to be of significance at the time of signing, but could come back to haunt you down the road, should your needs drastically change within the term.
One of these often "glossed over" conditions is the prepayment privilege.
What Is A Prepayment Privilege?
A prepayment privilege gives you the opportunity to pay off more than the regular mortgage payments you have agreed to pay in a mortgage contract. Prepayment privileges allow you to pay more than your regular payments without triggering any prepayment charge.
Different Types of Prepayment Privileges
Lump Sum Payments
Typical pre-payment scenarios on a closed term mortgage would allow a prepayment of the original principal balance each year based on the anniversary of the loan (usually with a minimum payment of $100). This is usually expressed as a percentage of the original principal of the mortgage that can be paid each year.
Some lenders calculate this period to be from calendar year to calendar year and some lenders calculate this period from anniversary date to anniversary date. The terms usually range from 10% to 20% of the original principal.
Increase in Regular Payments
This is usually expressed as a percentage increase of the contracted monthly payment. The increased allowable amount typically ranges from 10% to 20% of the original payment. Most lenders allow payments to be increased by switching to a bi-weekly accelerated or weekly accelerated payment schedule, in addition to your prepayment privileges.
Other "Custom" Options
Some lenders offer a "skip a payment" or "double a payment" option, with restrictions on how many times each can occur in a specified period.
Closed Mortgages Versus Open Mortgages
Closed mortgages generally have lower interest rates than open mortgages do, but borrowers are prone to less flexibility- mainly the loan can't be paid prepaid without avoiding a penalty. Most closed mortgages allow for accelerated payments of some kind (see above), but each lender sets its own prepayment terms.
With a closed mortgage, the client is essentially agreeing to keep the loan for the entire term. Borrowers who sell their can end up with less money than anticipated as a result of high penalties for breaking the terms of the mortgage.
An open mortgage comes at a higher interest rate, but also gives a homeowner the flexibility to pay off their mortgage any time. This in itself, could outweigh the interest rate difference between an open and closed mortgage.
If there are a lot of unknowns in the future in terms of job location, major life changes (ie getting married or expanding the family where a new home might be required), an open mortgage should be considered. If the next five to ten years (or however long the term of the mortgage is) looks fairly stable with very little change, a closed mortgage might be a better fit.
To sum it up: closed mortgage = lower interest rates with little flexibility and open mortgage = higher interest rates with a lot more flexibility.
How Are Prepayment Penalties Calculated?
In Canada, prepayment penalties on closed mortgages are generally calculated as either the sum of three months of interest on your mortgage or the interest rate differential (IRD), whichever is greater.
What Is An IRD?
An 'Interest Rate Differential (IRD) is a differential measuring the gap in interest rates between two similar interest-bearing assets. It is the difference between what you would have paid in interest and what the bank can now make on the funds they lent you, based on the current rates, for the remainder of your term.
If you were paying the bank 6% interest and they can now only lend the money out for 4%, you have to pay back the difference. The greater the time left on the term of the mortgage, the greater the IRD penalty, as the difference in interest is incurred for a longer period of time.
There are lots of IRD calculators offered online to satisfy any curiosity of what the approximate penalty would be to break the current terms of your mortgage. Armed with some info from your mortgage contract, simply populate the information into the calculator and a ballpark number will be produced- oftentimes it's shockingly high. There are generally more fees incurred at branch level in addition to the IRD figure, as well (ie discharge fees, etc).
Avoiding or Decreasing Penalties
The outright way to avoid a prepayment penalty on a mortgage is to not break the terms of the mortgage for the life of the contract (ie 5 years). Upon renewal, the terms of the existing mortgage contract have been satisfied and can no longer impose a penalty should the borrower wish to switch to a different lender or explore a different type of mortgage.
However, life can be unpredictable, and oftentimes curveballs can be thrown out of nowhere. If you find yourself in a situation where you need to break your mortgage terms, there are a few ways to reduce the penalty.
If you've confirmed what the penalty is through either your mortgage broker or bank, and if it's huge, check or ask about the above mentioned prepayment clauses in your contract. If you have money somewhere else that can be applied to a lump sum pre-payment against the principal, now would be a good time to use it.
With a mortgage of $400,00 and 36 months left on the term, a prepayment of $80,000 applied directly towards the principal before making the break, can effectively shave several thousand dollars off the penalty. Instead of incurring a $15,000 penalty, it might be brought down to $11,000-$12,000 by this strategic maneuver.
Sometimes it might even make sense to take out a short term loan to come up with the lump sum, if you're able to pay it off right away with the proceeds of the sale of your home or other means. The cost to temporarily borrow the money would often be much less than the savings on the penalty, making it a viable option to explore.
If a large lump sum payment isn't accessible, even doubling up your payment or making an extra full payment until you break the mortgage will help reduce the penalty. The time of year can play a role in saving money on a penalty, as well. If the terms of your contract are calendar year, you could take advantage of the prepayment privileges in both December and then again in January. Check with your lender first to determine if your terms are on a calendar year or anniversary basis, as you don't want to go through the trouble of securing funds to only find out they can't be applied to the principal in enough time to be of any advantage.
Subject to conditions explained below, the prepayment penalty might be deductible from your business income. If the criteria is met, the Income Tax Act redefines the penalty and instead deems it to be interest. From there, the normal rules for the deduction of interest apply, with some limitations.
Conditions For Deducting a Prepayment Penalty
For the deduction to be permitted, the penalty must be paid on money that you have borrowed in the course of carrying on your business or in the course of earning income from the property, otherwise know as "debt obligation".
The penalty must also be categorized as having been paid because of an early loan repayment and no other reason. The penalty will not be deemed "interest" if is calculated on variable elements, such as production of goods or dividends to shareholders. The penalty must be paid to compensate the bank for loss of interest on the loan, not for a participation in the business.
If you meet the criteria, the prepayment penalty is determined to be interest and becomes deductible from your income.
Prepayment Penalty Treated as a Capital Expenditure
If the Income Tax Act does not deem the prepayment penalty to be "interest", it is generally not deductible. There are three exceptions to this rule, though:
- The prepayment penalty was incurred in connection with the disposition of a capital property, in which case the penalty is taken into account when calculating the gain or loss from the disposition of that property.
- The prepayment penalty qualifies as an eligible moving expense and is deductible as such.
- The prepayment penalty qualifies as a current expense in the context of a particular business.
The Bottom Line
With high stakes, fine print and few ways around it, prepayments can be a tricky thing to navigate on your own. The best time to become educated on your options and their potential ramifications is before committing to a mortgage. A mortgage broker can offer an unbiased and broad range of pitfalls to avoid and guide you to the right mortgage for your needs.