Prepayment Privileges and your Prepayment Penalties
2020-10-09 | 10:54:55
Good morning everyone!!
Hope everyone is having a great start to their week!! Please continue to stay safe and healthy as we experience this uptick in COVID numbers in our Country.
For this week’s topic, I want to discuss the importance of knowing your prepayment privileges and your prepayment penalties when deciding and choosing your optimal mortgage product. Whether you are working with a mortgage mobile specialist directly in one of our major Canadian banks or a mortgage professional such as yours truly, it is important that you are aware of what both are and how they can help or hurt you during the term of your mortgage.
PREPAYMENT PRIVILEGES
Simply defined, prepayment privileges are offered to borrowers in various forms from all lenders; allowing for a pre-determined percentage and/or lump sum of a mortgage to be paid, over and above the monthly payment without penalty during each calendar year in the term of a mortgage.
When you are asked the many probing questions from a mortgage professional that may include: your goals, your family plans, the type of employment you have and whether there will be financial changes to your income; you as the borrower, are asked to be as transparent as possible. This ensures that we align your goals and financial profile with the best mortgage product.
Sidebar: the best mortgage product does not mean getting the lowest rate! Most times, the lowest rate is not in your best interest.
Back to our discussion - when working directly with one of the big banks, you will only have access to their prepayment privileges.
When working with mortgage professionals such as myself, you will have the benefit of having dozens of lenders to choose from, including some of the major banks. The benefit to prospective borrowers not only allows the search for the best rate for their particular file but, to have a mortgage product that aligns with the borrowers present and future plans so to allow paying down their mortgage more aggressively.
In many cases where you are seeing the lowest mortgage rate, there are usually no strong prepayment privileges attached. It is true that COVID has created a deceleration of mortgage prepayments across our country; however, many Canadians use this instrument to pay down their mortgages sooner and, want to know that they have access to paying down their mortgages earlier if they are able to.
Some examples of pre payment privileges are as follows:
- 10% + 10%
- 15% + 15%
- 20% + 20%
- 20% + 20% + double up
The figures mentioned above, offered by various lenders, allows the borrower to pay down their principal (the amount you borrowed) by a certain percentage each month and, once per year without penalty. In some cases, as shown above, you could double up your payments without incurring any financial penalties.
For example, if you have a $400,000 mortgage, using the 20% example, one can pay, without any financial penalty, 20% more of the principal portion of their monthly payment – 20% of the original mortgage amount ($80,000 – once per year of each year of term) and/or double up on a monthly payment over a prescribed number of times over the course of one year.
It is important to note that we are discussing closed mortgages above rather than open mortgages. Bank rates for open mortgages are in some cases more than double the rate of closed mortgages; however, one’s decision to choose an open mortgage is sound if they have mentioned that they intend to receive a large inheritance or huge bonus that can pay off a huge chunk or the entire mortgage.
In contrast, if the borrower has no intention of paying more than their monthly mortgage payment or, have the ability to pay down any percentage of their principal once per year, a mortgage product that does not flaunt these privileges is best for them.
This because, as mentioned above, mortgage rates are typically lower when not attached to bells and whistles such as strong prepayment privileges.
By knowing your present and future plans, I can ultimately save you thousands of dollars by placing you in a mortgage product that is structured with strong prepayment privileges or not.
PREPAYMENT PENALTIES
A mortgage holder (any lender) earns interest on the principal amount of any mortgage. If the borrower, in the case of a closed mortgage, decides to pay down more, or for the purpose of this discussion, break their mortgage before the end of their contracted term, a financial penalty is paid to the lender.
As with prepayment penalties, it is crucial that the borrower be as transparent as possible when highlighting their present and future goals – especially when choosing the common 5 year term. In fact, 51% of Canadians choose a 5 year term. All lenders earn more by charging higher interest rates as the number of years in a closed mortgage term goes up. Note, a 10 year posted fixed rate today is approximately 1.5% higher than a 5 year posted rate.
For many, especially first time homebuyers, the allure of the 5 year fixed rate comes from the peace of mind that they will have a set monthly payment that will not change for the next 60 months. "Set it and forget it."
However, nearly 2/3 of Canadians break their mortgage before the third year of a 5 year term.
Depending on your personal circumstances, a fixed rate 5 year term, as enticing as it is, especially today where they are as low as variable rates, can be financially devastating if you break your mortgage for whatever reason before the end of said term.
When there is so much uncertainty in our daily lives - planned or unplanned events, including: changing jobs with lesser pay, changing jobs with much higher pay, the birth of one or more kids, illness, disability or huge inheritance, yours truly believes a variable rate is still the way to go.
It is important that those who are determined they will only agree to a fixed rate mortgage are introduced to monoline lenders or credit unions whose prepayment penalties are much more forgiving than those of the Big Banks. The benefit of partnering with a mortgage agent gives borrowers the peace of mind that their financial situation can be best served by investigating which lender will best match with their own financial reality.
This because, if you ever need to break your mortgage with a big bank as a result of a refinance or sell/purchase years prior to the end of your 5 year term, the breaking of a variable rate mortgage comes attached with a 3 months interest charge penalty. For a fixed rate mortgage, an IRD charge (Interest Rate Differential) is attached if breaking your mortgage creates a financial loss for the lender greater than the cost of 3 months of interest that the lender would have earned.
In contrast, breaking a 5 year fixed mortgage with one of the Big Banks is frightening compared to its variable counterpart.
For example, imagine a 2.68% interest rate for a 5 year fixed mortgage with a remaining balance of $400,000 with RBC that originated on September 20, 2017.
Your penalty with a 5 year fixed mortgage would come to at least $14,250.00. Depending on the details in the mortgage contract, other fees may apply over and above the said penalty amount. I've seen it too many times!!!
With a 5 year variable mortgage, the charge to you for breaking the mortgage would be, $2,930.00. That is a savings of (at least) $11,320.00 for the same rate and length of term at the same lender.
I could elaborate and get into further details of how the IRD charge is calcualted. Please connect with me for a further explanation but, the example above is clear enough to highlight what charges await you in the event of a break in your mortgage term whether you choose a fixed or variable rate a couple of years into your 5 year term.
Everyone’s exuberance gets the better of them when purchasing their first or subsequent home. It is vital that the advice, guidance and facts you receive from your mortgage professional matches your financial profile and objectives when deciding on the best mortgage product that ultimately allows you better flexibility in paying down more of your mortgage sooner - if you are likely to do so.
Most importantly, the advice, guidance and facts you receive from your mortgage professional that creates an open and honest conversation on the what if’s that life throws us – good or bad – is even more crucial when considering the financial fallout caused by having to break a mortgage before the end of a fixed term.
Looking forward to your calls, comments and questions, please let me know how I can help you and/or a friend who requires information that ultimately calms concerns while maintaining the thrill of home purchasing – all because of the small but vital details that you need to know before deciding on what mortgage product (not only rate) works best for you.
Wishing you a great week ahead!!
Marco
