The Tradeoff With Big Prepayment Privileges



Prepayments-MortgageMost 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
10% $25,000 $206
15% $37,500 $309
20% $50,000 $411
25% $62,500 $514
30% $75,000 $617

 

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

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Comments

  1. Comment avatar

    Observer    

    It’s true that 10% + 100% double UP is in most cases enough.
    The bad is that 10% is set to be only once a year.
    For comparison, ING gives you 25% and you can pay whenever you want whatever amounts you have up to that 25% of the original balance.
    I feel that is what BIG banks should change : the 10% to be payable on at least 5 times during a year.

     
  2. Comment avatar

    S Lee    

    Most lenders with 10% lump sum pre-payments let you make multiple instalments any time during the year. RBC is the only exception I can think of.
    Who else are you talking about Observer?

     
  3. Comment avatar

    Jeff Norris    

    I think there is something to be said for ease of prepayments as well. My current lender, a credit union, requires paperwork and trip to the head office in order to make a prepayment. My previous lender allowed it to happen online. I am disciplined so I will still fill out the forms and make the trip. However, I can see how some may delay making a prepayment as a result of the hassle.

     
  4. Comment avatar

    Observer    

    TD Canada trust, I think

     
  5. Comment avatar

    TD MMS    

    You are incorrect Observer. TD permits one or more prepayments totalling 15% of the original mortgage amount per calendar year.

     
  6. Comment avatar

    J/W    

    I can’t make prepayments online with my mortgage now and I hate it. Then again I’m not sure if I’d pay 5 basis points more for this convenience.

     
  7. Comment avatar

    Observer    

    my bad then, sorry, great to know TD offers this flexibility

     
  8. Comment avatar

    John    

    TD also allows up to double principal payments on the monthly that can be applied or canceled any time, in addition to the lump sum payments.
    A very flexible policy.

     
  9. Comment avatar

    Lior    

    A few lenders allow you to do that. True, it’s a very flexible arrangement but hardly exclusive to TD.

     
  10. Comment avatar

    Lior    

    Very good analysis, Rob. There’s definitely no reason to overpay for prepayments if the homeowner doesn’t intend to make full use of the privilege. Moreover, we can’t accurately predict where rates would head which is why it’s futile to bet that a higher prepayment privilege would save the homeowners money on some the penalty costs.
    If you allow me to expand on the subject a little bit, both CAAMP and CMHC research has shown consistently that most homeowners really would like to pay off their mortgage sooner but in reality few actually do it. Financial institutions have no problems offering consumers high prepayment privileges at low rates because they know the vast majority of people out there never take advantage of it. For brokers and bankers, competing on prepayments is a useless value proposition. So if the intention to prepay is there, why then do most homeowners not follow up?
    One of the things we’re doing (and have done for the past few months) is include a prepayment plan with the mortgage plan we present. We talk with clients about realistic goals and we set a prepayment plan in motion based on their cash-flow and other financial objectives. Financial goals are easier to achieve when they are planned on paper with realistic numbers. The task becomes easier to complete especially once other expenses are account for. Generally, we recommend that more prepayments are pushed in the beginning because that’s when the allocation to interest is greater and the principal amount is higher.
    To motivate clients to prepay their mortgage, we show them the amortization table and the allocation to interest at the beginning of the term. When most people see that 70% of their mortgage payment, their hard-earned money, covers just interest and that for first-time homeowners the first few years they’re hardly building any equity in the property, it really drives the point home. Why save your money at the bank at 1% interest (sometimes even less) when you can put some of it towards your mortgage and earn a real ROR of 3% or 4% depending on your current mortgage rate?
    Another thing to remember about prepayments is that baby steps deliver tangible results in the long run. While it true that larger periodic lump sums throughout the year save homeowners the most amount of money during compounding periods, small prepayments timed throughout the year do make a difference in the medium and long term. You just need to have a plan first.

     
  11. Comment avatar

    Robert McLister    

    Hi Lior, Thanks a bunch for sharing this. I love that you take the time to plan prepayments with your clients on paper. This sort of service adds material value and makes a mortgage much more than just a wham-bam-thank-you-ma’am transaction…

     
  12. Comment avatar

    David Hyder    

    The prepayment “privilege” is an embedded call option, and is worth quite a bit of money. You can calculate exactly how much by calculating the value of such an option on a bond with a duration similar to the duration of your mortgage.
    Furthermore, it is not true that you can only exercise this option if you have excess cash, since you can borrow against equity to do so.
    For example, a person with a long fixed rate can borrow against the equity in the home at low short rates to prepay (in a HELOC, for instance) if rates go against them. They then have a blended rate, and if rates go up again, they can concentrate their payments on paying off the HELOC.
    In short, a long rate with a large prepayment option is a great combination. I do agree, though, that it is not worth paying up for the option, just that one should factor it into one’s calculations as a potential positive.

     
  13. Comment avatar

    Henry    

    Hi
    You lost me at embedded call. Can you please explain how prepayments are worth “quite a bit of money” for someone without quite a bit of money?? If you can put that in terms that a 53 year old autoworker can understand that would be great.
    One more thing. Why would I want to borrow from my HELOC at 3.50% to prepay my 3.39% fixed mortgage?

     
  14. Comment avatar

    David Hyder    

    “Can you please explain how prepayments are worth “quite a bit of money” for someone without quite a bit of money.”
    Sure: When you take out a mortgage, you are issuing a (non-negotiable) bond to a bank, much like a corporation would issue a bond to raise funds. The cashflow structure of a mortgage is a little different, but the principle is the same.
    Similarly, an option to prepay is a call on your mortgage bond, just as e.g. a 30-yr corporate bond could contain a call provision to allow the issuer to buy the bond back at some specified price (in the original bond agreement) earlier if they choose.
    An issuer would do this if he wanted to borrow long, but wanted the assurance that he could change his mind if rates moved badly against him.
    If you look at the corporate bond market, you can see what the price of such a call feature is by comparing the yields on bonds of equivalent quality, maturity and credit quality, where one bond has an “embedded call” and the other is the straight bond.
    This will tell you what the market price (the yield premium) for such a call option is. This price is “objective” since it reflects the price that borrowers, including banks, must pay to obtain funds and hedge risk on the very money they loan *you* as a mortgage.
    What does this mean practically? You might want, like a corporation, to lock in rates but still hedge against the possibility that you are wrong. In that case, that option is quite valuable to you.
    Because, as Rob correctly states, most people do not exercise these options, banks may throw them in as teasers. The same applies for rate holds, BTW. They are quite expensive in the market (equivalent call options), but the banks give you these options as a teaser to get your business.
    In response to your last question, there is little value in such options if you are not locking in, because you have not entered into a long-term commitment you might want to get out of.
    Hope that is helpful.

     
  15. Comment avatar

    David Hyder    

    Hi, I wrote a long answer, but it won’t post. Sorry.

     
  16. Comment avatar

    CMT    

    Hello David,
    Your post got temporarily hung up in the spam filter for some reason. It is now live below in its entirety.
    Thank you for posting.
    Cheers,
    Elizabeth

     
  17. Comment avatar

    banker in an ivory tower    

    David, Impressive dissertation. I am speechless!
    Henry, Did you get all that?

     
  18. Comment avatar

    David Hyder    

    Maybe, but what I said contains two errors: mortages are negotiable, that’s what got us into this whole mess! And rate holds are puts, not calls.

     
  19. Comment avatar

    Theta    

    David,
    The flaw in your analogy is that mortgage prepayment privileges don’t give the “issuer” (homeowner) the right to “call” (prepay) 100% of the “bond” (closed mortgage).
    Therefore a 20% prepayment option is minimal benefit for the strategy you propose, which is breaking the mortgage to take advantage of a better rate. You also must acknowledge the penalty someone pays to break a mortgage.

     
  20. Comment avatar

    Darius Degross    

    There are many reasons as to why people prepay their loan, but the usual reasons are to shorten up their loan tenure and to own their asset earlier. And it can be a good move for those who have recently gotten a bonus, or are able to pay it big.

     

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