Mortgage Prepayment Privileges and Penalties in Canada
Prepaying your mortgage can be one of the most effective ways to reduce interest-carrying costs and shorten the time to becoming mortgage-free. Understanding your mortgage contract’s prepayment privileges and potential penalties is essential to avoid costly mistakes and create a comprehensive mortgage strategy.
We will explain what you need to know about mortgage prepayment in Canada, including how it works, the options available, and tips to maximize your savings.
Key Takeaways
- Mortgage prepayments allow you to pay off your mortgage faster and save on interest-carrying costs.
- Your prepayment privileges allow you to make lump-sum payments, increase your regular payments, or round up your payments.
- Prepayment penalties may apply if you exceed your lender’s annual prepayment limits.
What Is a Mortgage Prepayment?
A mortgage prepayment is any payment made toward the principal balance of your mortgage outside of your regularly scheduled payments. Prepayments reduce your principal immediately, reducing the total interest paid over the life of the mortgage.
Prepayment options vary by lender and are determined by the terms of your mortgage contract. They can include making a lump-sum payment, rounding or doubling up your mortgage payments, or increasing your regular mortgage payment amount or its frequency.
Before making any prepayments, you must understand what your lender allows and any limitations they may impose. The prepayment limit is typically calculated as a set percentage (ex. 10%) of your mortgage balance at the start of each term.
Types of Mortgage Prepayment Privileges
Canadian homeowners have 3 ways to prepay their mortgage:
- Lump-Sum Payments: A one-time payment toward the principal balance of the mortgage. These payments can be made at any point during the term, but most lenders set annual limits (often 10% to 20% of the original principal each year) to avoid penalties.
- Increase Regular Payments: Even a small increase in your regular mortgage payment can reduce the overall interest owed. However, you must ensure the increase in your payments doesn’t exceed your lender’s annual limits. For example, your monthly mortgage payment is $1,500, and you decide to increase it to $1,700.
- Rounding or Doubling Up Regular Payments: Rounding or doubling up your payments works the same way as increasing them. For example, instead of paying $1,576 a month toward your mortgage, you may round up the payment to $1,600. While rounding up may only increase your payments by a small amount, the rounded portion goes directly toward the principal, helping you save on interest and pay off your mortgage faster. Some lenders will also offer the option of doubling up your payments; your mortgage payment frequency stays the same, but your payment simply doubles.
Although there are multiple ways to prepay your mortgage, your combined prepayments cannot exceed the allowable limits as per your mortgage contract.
What Are Mortgage Prepayment Penalties?
Prepayment penalties are fees that a lender may impose if you exceed your prepayment privileges or break your mortgage contract early. These charges are designed to compensate the lender for the loss of interest income they would have earned had you continued with the original payment schedule.
Calculating Prepayment Penalties
For closed variable mortgages, prepayment penalties are usually calculated as 3 months of interest on the outstanding balance. This makes them one of the most predictable and, often, the option with the lowest penalty.
For closed fixed-rate mortgages, the penalty is typically the greater of 3 months of interest or the Interest Rate Differential (IRD). The IRD formula compares the calculated penalty between your current mortgage rate and the lender’s posted rate on a comparable term.
There are 2 ways that lenders may calculate the IRD penalty: through a Standard IRD calculation or a Discounted IRD calculation. The standard calculation only compares your current mortgage rate with the lender’s posted rate on a comparable term. In contrast, the discounted calculation compares your current mortgage rate with the lender’s posted rate on a comparable term, minus any discounts you received on your current rate.
Typically used by Canada’s Big Banks, the discounted IRD calculation makes this penalty more costly than the standard IRD and the 3-month interest calculations. Some institutional lenders will also add a reinvestment fee to this calculation, making it difficult to determine the exact penalty amount without contacting the lender directly.
How to Avoid Prepayment Penalties
To avoid prepayment penalties, you must stay within the annual prepayment limits outlined in your mortgage contract. If you anticipate making a larger prepayment, choose a lender with higher prepayment limits to avoid penalties. If you anticipate refinancing, selling, or upgrading before the end of your term, the cost of breaking your mortgage may outweigh the benefit of having larger annual prepayment limits.
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Open vs Closed Mortgages
Open mortgages allow unlimited prepayments and give you the ability to pay off the mortgage at any time without penalty. However, open mortgages come with the trade-off of higher interest rates. This makes them best suited to short-term or transitional mortgage strategies rather than for long-term borrowing needs.
Closed mortgages offer lower interest rates but limit prepayment privileges. Lenders charge prepayment penalties for exceeding these limits or for breaking the mortgage before the end of the term.
Closed fixed-rate mortgages limit the amount of prepayments you can make annually and typically have higher penalties that reduce flexibility if you need to refinance, sell, or break the mortgage before the end of the term. In a falling interest rate environment, IRD penalties can be substantial.
Closed variable mortgages typically offer prepayment privileges similar to those of fixed-rate mortgages, but use a simpler penalty calculation based on 3 months of interest.
What Is the Best Mortgage Type for Flexibility and Prepayments in Canada?
There is no single best mortgage for flexibility in Canada, and the right choice will vary from borrower to borrower. The best mortgage for your situation depends on how long you plan to keep the mortgage and whether you anticipate making significant prepayments or other changes during the term.
How Flexibility Differs by Mortgage Type
Open mortgages offer the highest level of prepayment flexibility. Borrowers can make unlimited prepayments, increase their regular payments at any time, or pay off the entire mortgage balance in full without penalty. There are no prepayment penalty calculations to consider for exceeding limits or paying off the mortgage in full before the end of the term.
The trade-off for this flexibility is cost. Open mortgages typically have significantly higher interest rates than closed fixed or variable options. Over the long term, this higher rate can outweigh the benefits of unlimited prepayment privileges if you are not actively using them.
For borrowers who value maximum flexibility and anticipate short-term changes, an open mortgage may be the most suitable option. Borrowers who value flexibility but do not want to pay the higher interest rate of an open mortgage often find that a variable mortgage provides a balance between open and fixed closed options. Fixed-rate mortgages may suit borrowers who prioritize payment stability and do not anticipate exceeding prepayment limits or breaking the mortgage before the end of the term.
When Paying a Higher Rate for Flexibility Is Worth It
Open mortgages are best suited to short-term or transitional strategies. For example, paying a slightly higher rate for 6 months may cost less in the end than breaking a fixed-rate mortgage and paying a large penalty. An open mortgage can also be a great option for borrowers who anticipate an inheritance or substantial bonus they want to apply to their mortgage, and that would exceed the prepayment limits of a closed mortgage.
However, using an open mortgage for several years often results in higher total interest costs compared to closed alternatives with more limited prepayment privileges. The structure is designed for flexibility first, not rate optimization. Open mortgages deliver unmatched prepayment flexibility, but they work best when paired with a clear short-term plan to transition to a closed mortgage or pay the balance off in full.
Mortgage Prepayment Alternatives
Accelerating your mortgage payments is one of the most effective ways to reduce the total interest paid and pay off your mortgage sooner. When you choose an accelerated payment schedule, such as weekly or biweekly, you are not simply spreading your monthly payment over the year; you’re paying more toward your mortgage principal with each payment.
These additional prepayments to your principal reduce the interest calculated the following month. This is especially true for variable and adjustable mortgages, which compound more often (monthly or 12 times a year) than fixed mortgages (semi-annually or twice a year).
For example, you make half your monthly payment every two weeks with an accelerated biweekly schedule. Since there are 52 weeks in a year, this results in 26 half-payments, totalling 13 monthly payments. This effectively means you are making one extra payment each year. This additional payment goes directly toward reducing your principal, leading to lower interest charges over time.
Beyond the financial benefits, accelerated payments can also help you build equity faster, which can be advantageous if you plan to sell or refinance your home. Over time, choosing an accelerated payment frequency can result in substantial savings. This approach can be ideal for homeowners who want to pay off their mortgage faster without significantly increasing their mortgage payments, or who do not have the additional funds to make a lump-sum prepayment.
Frequently Asked Questions (FAQ) About Mortgage Prepayments in Canada
What are prepayment privileges in Canada?
Prepayment privileges allow mortgage holders to make additional principal payments without incurring prepayment penalties. These privileges usually include increasing regular payments or making lump-sum payments within a set annual limit.
What happens if I exceed my prepayment limit?
If you exceed your annual prepayment privilege, the excess amount may be subject to a penalty based on your mortgage type and the calculation the lender uses. Always confirm your available prepayment room with your lender before making a large payment. Your prepayment limit is non-cumulative and resets each year or on your mortgage anniversary date.
What is the maximum amount I can prepay without penalty?
Most lenders in Canada allow you to prepay up to 10% to 20% of your mortgage’s principal balance at the start of the year or your mortgage anniversary date without incurring penalties. The timing and frequency of your prepayments may be limited by the mortgage and lender you choose.
Which mortgage has the lowest penalties in Canada?
In Canada, open mortgages have no prepayment penalties, making them technically the mortgage with the lowest penalty. However, among closed mortgages that charge prepayment penalties, variable mortgages typically have the lowest based on 3 months of interest. Fixed-rate mortgages often carry a much higher penalty, as they are usually calculated using the Interest Rate Differential (IRD), unless the 3-month interest is greater.
How can I reduce mortgage prepayment charges?
To reduce prepayment charges, consider an accelerated payment frequency, staying within your annual prepayment limits or using options such as mortgage porting or conversion (switching from variable to fixed) to avoid penalties.
Final Thoughts
Understanding and leveraging prepayment options can save you thousands of dollars in interest costs over the life of your mortgage while helping you pay it off faster. Mortgage prepayments are an easy way to pay more of your mortgage principal. Even small amounts applied directly to your mortgage principal can help you save significantly on interest-carrying costs and pay off your mortgage sooner.
Reach out to nesto mortgage experts for personalized advice to find your most suitable prepayment strategy and become mortgage-free faster.
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