Mortgage Prepayment Privileges and Penalties in Canada
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Prepaying your mortgage can be one of the most effective ways to reduce interest-carrying costs and shorten the time it takes to become mortgage-free. Understanding your mortgage contract’s prepayment privileges and potential penalties is essential to avoid costly mistakes and create a comprehensive mortgage strategy.
Our guide will explain everything you need to know about mortgage prepayment in Canada, including how it works, the different options available, and tips for maximizing 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 regular payments, change your payment frequency, and round up payments.
- Prepayment penalties may apply if you exceed your lender’s annual prepayment limits.
What Is Mortgage Prepayment?
A mortgage prepayment allows you to make additional payments toward your principal in addition to the portion of your regular mortgage payments that goes toward the principal. These extra payments can significantly reduce the total interest you pay over the life of your loan.
In Canada, prepayment options vary between lenders and based on the terms of your mortgage contract. They can include making a lump sum payment, rounding up your mortgage payments, accelerating your payment frequency or increasing your regular mortgage payment amount. 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 Options in Canada
Canadian homeowners have 4 ways to prepay their mortgage:
- Make Lump-Sum Payments: This is a one-time payment made toward the principal portion 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 Your Regular Payments: Increasing your regular mortgage payment, even a small amount, 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 payments are $1,500, and you decide to increase your payment to $1,700.
- Rounding Up Regular Payments: Rounding 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.
- Accelerate Your Payments: Adjusting the frequency of your mortgage payments, even if they are not technically considered prepayment privileges, can significantly reduce the duration of your loan. By making payments more often, you can pay off your mortgage quickly, shortening your amortization by several months or even years. This simple adjustment can lead to substantial savings, possibly lowering your overall interest-carrying costs by thousands of dollars over the life of the mortgage.
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-rate mortgages, prepayment penalties are usually calculated as 3 months of interest on the outstanding balance. 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 your current mortgage rate with 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 3 months of interest calculations.
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. You can also choose an open mortgage, allowing you to make as many prepayments as you like without limitations and penalties. However, open mortgages come with higher interest rates in exchange for flexibility.
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Benefits of Accelerating Your Mortgage Payments
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 into smaller chunks; you’re paying more toward your mortgage over the year.
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); these additional prepayments to your principal reduce the interest calculated the following month.
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, which equals 13 total 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.
Using Mortgage Prepayment Calculators
A mortgage prepayment calculator is invaluable for homeowners looking to optimize their mortgage prepayment privileges. These calculators allow you to simulate various prepayment scenarios, such as making lump-sum payments or increasing regular payments, so you can see how much time and interest you can save over the life of your mortgage.
Most calculators work by asking for critical details, such as your outstanding mortgage balance, interest rate, and current payment schedule. You can experiment by inputting different prepayment amounts as a one-time lump sum or a regular payment increase. The calculator then provides instant feedback, showing how these changes would impact your mortgage’s amortization and total interest costs.
In addition to understanding how prepayments affect your mortgage, these calculators often include features to help you estimate potential prepayment penalties. This is especially useful if you consider paying down more than your mortgage contract’s annual prepayment privilege allows. Using a mortgage prepayment calculator, you can strike the right balance between paying off your mortgage faster and avoiding unnecessary costs.
Frequently Asked Questions
What are prepayment privileges in Canada?
Prepayment privileges allow mortgage holders to make additional payments toward their principal without paying prepayment penalties. These privileges usually include increasing regular payments or making lump-sum payments within a set annual limit.
How are mortgage prepayment charges calculated?
Prepayment charges for fixed-rate mortgages are calculated as the greater of 3 months of interest or an interest rate differential (IRD). Variable-rate mortgages are typically calculated based on 3 months of interest.
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 original principal balance each year without incurring penalties. Although, when and how often you can spread out your prepayments may be limited by the mortgage and lender you choose.
Can I avoid prepayment penalties by using an open mortgage?
Yes, open mortgages allow unlimited prepayments without penalties. However, they often have higher interest rates than closed mortgages. Instead, you could consider a HELOC if you’re financially disciplined, which can work similarly to an open mortgage but with a lower interest-carrying cost as there is no amortization of your principal balance.
How can I reduce mortgage prepayment charges?
To reduce prepayment charges, consider staying within your annual prepayment privilege limits or use options like mortgage porting or conversion (switching variable to fixed) to avoid penalties.
Final Thoughts
Understanding and leveraging prepayment options can potentially save you thousands of dollars in interest costs over the life of your mortgage while helping you pay off your mortgage 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.
Reach out to nesto’s mortgage professionals for expert, commission-free and personalized advice and find your most suitable prepayment strategy to become mortgage-free faster.
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