Most decent mortgages come with at least 10% lump-sum prepayment privileges.
Since the average mortgage is about $151,000, that means the typical borrower can prepay at least $15,000 per year in lump sum(s) with no penalty.
The thing is, most Canadians don’t come close to paying 10% extra on their mortgage over the course of a year. In fact, only 17% of mortgage holders made any lump-sum prepayments at all in 2011. Those who did likely prepaid an average of ~7.8% of their mortgage balance over the course of the year.¹
It’s therefore safe to say that most people will never max out their prepayment privileges.
The exceptions are people with:
- small mortgages (where it’s easier to make a big prepayment)
- cash windfalls
- big bonuses
- the means to make a big prepayment before breaking their mortgage early.
That last case (prepaying before breaking) is typically done to reduce the balance the lender uses to calculate its prepayment charge. That can sometimes save you a fair amount if you’re facing an IRD penalty.
Nowadays, however, a 3-month interest penalty is usually more likely on new mortgages. That’s because the prospect of higher future rates reduces (albeit not eliminates) the likelihood of an IRD charge.
If we use a sample $250,000 mortgage, we can see what prepayment privileges equate to in dollars. We can also estimate how much a hypothetical mortgagor would save in penalties by making the biggest possible prepayment right before breaking his or her mortgage…
|Prepayment Allowance||Dollar Equivalent||Amount of Penalty Saved ²|
The penalty savings and the maximum dollar amount one can prepay will differ, depending on the lender, penalty type, and size of the mortgage.
It’s clear, however, that paying a higher rate for large lump-sum prepayment privileges is usually senseless if you do it to save on potential mortgage breakage fees. Other things being equal, you’d be just as well off trading some prepayment flexibility for a mortgage that is five basis points cheaper. Doing so nets you interest savings over five years that is roughly the same or greater than the potential penalty savings.
On a related note, despite lower lump-sum flexibility you can still usually increase and/or double-up your regular payments.
The moral is not to overpay for extra prepayment options unless there’s a good probability you’ll use them. 20-30% lump-sum privileges are generally overkill for most of us.
¹ According to the latest available CAAMP data on this matter from 2010.
² This is an approximation of how much someone would save on their penalty if they maximized their prepayment privileges before discharging the mortgage. Assumes a 3-month interest penalty on a five-year fixed mortgage with an initial amount of $250,000 and a rate of 3.29%. Also assumes the mortgage is broken after three years with a $230,000 balance at the time.
Rob McLister, CMT