Buying a house is one of the biggest financial decisions one makes. While the effort is to make a realistic projection, since the term of a mortgage is long, financial situations can change along the way.
One of the decisions mortgage borrowers often need to take is whether to pay off their mortgage earlier than the planned period, or not. This is what might be referred to as a ‘happy’ problem. You are facing it because you have possibly come into money that was not foreseen at the time you took the mortgage loan; hefty bonus, winning the lottery, inheritance, there could be many reasons.
Does it make sense?
On the face of it, repaying early, if you have the money, would make sense as it will save you the accrual of interest on outstanding loan amounts and make you debt-free faster.
However, one of the fundamental principles of managing money is that of ‘Opportunity Cost.’ All resources, like money, have multiple uses. By putting them to one use, they are deprived from being deployed to other uses. Hence, while making a choice, it should be determined that the chosen use is the most financially profitable choice, keeping taxes and other variables into account.
In case of a mortgage loan, the benefit is of reducing the future interest outgo, and that will generally be a winning argument. However, the interest savings need to be weighed against the prospect of reducing interest on other, more expensive loans, and earning from possible investment opportunities that exist at that time. In other words, are there other, better uses for the money?
Can you prepay?
Once you have determined that it makes sense to prepay, the next question is: Can you?
The answer often lies in the type of mortgage you have taken out and the terms and conditions governing the contract. As a general rule, the closest you were able to project your future financial situation and cash flows, the more favourable the terms are likely to be.
This is because one of the reasons lenders, usually banks, are able to offer the finest rates for mortgage loans is that the cash flows are well defined and allow them the ability to build these flows into their own business plans. Deviations, that cause those plans to change, are penalized. At the same time, if the borrower wants greater flexibility in the contract, the rate usually becomes higher.
So, what is a borrower to do? Many first-time home buyers would rather have lower interest rates now than greater repayment flexibility later, which will have an additional cost starting now.
Type of Mortgage
One way of classifying mortgages is as Open and Closed mortgages and influences prepayment choices.
An Open mortgage allows flexibility in repayment, without additional charges. In other words, a part of those charges may have already been built into the rate offered.
A Closed mortgage defines the schedule and amount of repayments. Some may offer limited flexibility, which is known as ‘prepayment privilege,’ either as a lump sum payment or an increase in the regular amounts.
Prepayment strategies
Increase the amount of regular payments – The contract will usually govern how much you can increase by, and penalties, if applicable. Once increased, the amount cannot be reduced. If required, it would tantamount to renegotiation.
Make a lump-sum payment – A lump-sum payment can be made, if permitted by the contract, on top of the ongoing payment schedule. These payments may be allowed:
- before the term ends
- when the term ends
- other defined times or dates
Prepayment penalty – strategies for reduction or avoidance
Penalties may be unavoidable in the event of either not abiding by the terms of the contract or trying to change them during its currency. How you can try to minimize the impact in case of prepayment:
Max out prepayment privileges – Penalties are usually calculated on outstanding balances; already having maxed out the privilege will have reduced the outstanding balance.
Prepay at the end of the term – In many cases these are permitted without a penalty.
Mortgage porting – If you can get another lender to take over the mortgage, and slip in your repayment requirements into it, nothing like it.
The Financial Forum for borrowers
The Financial Forum makes mortgages easy for borrowers, helping them crystallize their needs, deciding on the right mortgage and addressing prepayment calculations and concerns. Reach us on (905) 265-0246 or mortgages@thefinancialforum.ca.
