When Prepayments Matter

Mortgage-prepayments Most people know that a low rate isn’t everything when shopping for a mortgage.  There are lots of reasons why that’s true.  Prepayment privileges are one such example.

Depending on your disposable income, prepayment privileges may mean a lot or they may mean nothing.  If you have the money to make them, they’re one of the best zero-risk investments you’ll ever find. 

(Prepayments can drastically reduce the interest you’re stuck paying with after-tax dollars. For someone in the 40% tax bracket, for example, a prepayment on a 5% mortgage is like earning a guaranteed 8.33% return.)

For this exercise, let’s assume one has the money and desire to take full advantage of prepayments.  In this case, we’ll turn to Joe P. Borrower who is presently evaluating two mortgage options:

Option A:  A 5-year mortgage at 4.49% with 20% annual prepayment privileges

Option B:  A 5-year mortgage at 3.99% with 15% annual prepayment privileges

(Assumptions: A $200,000 mortgage and 25 year amortization)

Other things being equal, probably 9 out of 10 people would gravitate to option B for the better rate alone.

If you have the means and plans to maximize your prepayment privileges, however, option A will actually save you more money.  Joe Borrower would save about $1858 in interest over 5 years by taking advantage of the additional 5% prepayment privileges in option A.  That’s real cash money.

The point is that a mortgage’s terms can sometimes offset a much lower interest rate. Mortgage professionals add value by explaining these scenarios.  Therefore, if you’re simply sending your application to the lender with the best advertised rate, you might be doing yourself a disservice.


Update: February 6, 2009

Below are two other points that were not in our original article. These points were noted by our helpful readers.

  1. Larger prepayment privileges can also save you money if you break your mortgage contract early (e.g.  when you sell your property outright or refinance).  In such cases, making a bigger prepayment before paying off the mortgage reduces your interest penalty. (Just ensure you make your pre-payment before you request the discharge.)
  2. Some lenders allow prepayments only once a year. This lack of flexibility means you will pay more interest in the interim while you are awaiting your prepayment date.
  3. Citizens Bank has a good prepayment calculator where folks can run their own pre-payment calculations.
  1. You really have to wonder how many families can afford to put down an extra $30,000 per year (Option B) on their mortgage let alone $40,000 per year (Option A).
    I agree that if a family assumes they’ll be able to put an extra $10,000 than option A is the better mortgage but how often does this type of scenario come up in the real world?
    In most situations, interest rate will be the #1 priority simply because most prepayment priviledges will be plenty for the average buyer. I also imagine that the families who could truly benefit from the extra prepayment flexibility probably have someone else looking into all these details for them as opposed to the average reader of this blog. Although I could be wrong about this..
    However, I believe the following features are important to the average buyer for various reasons:
    -Some prepayment flexibility: This is generally one of the more important features for families who feel their income may increase in the foreseeable future. Most lenders seemed to offer at least 10% annual prepayment and the ability to increase your monthly payment by 10% which is probably more than enough for most families. (10% of $200,000 is $20,000 so how many people can all of a sudden afford to put an extra $20,000 on a mortgage each year?)
    -Open vs Closed mortgages: Giving yourself the ability to pay off a mortgage entirely or transferring it to another financial institution if you want to shop a little longer but are under pressure to close a deal or if you think that better mortgage options will be available shortly.
    -Portability: The ability to transfer the remainder of your mortgage to a new property if you happen to sell your existing property for another one during your term.
    -Assumability: The ability to transfer your mortgage to the person purchasing your property in the future.
    -Property tax inclusion/exclusion: Not sure what this feature is truly called but it is the ability to include or exclude property taxes from the mortgage so that you can either have them automatically paid through your mortgage (which means that property taxes are added to the mortgage and that you pay mortgage interest on your property taxes) or that you pay for your property taxes independently from your mortgage which means that your overall cost of living is higher but you don’t have to pay interest on your property taxes.
    I found it odd that not many lenders seemed to offer the ability to pay your property taxes independently from the mortgage. Most lenders seemed to want property taxes to be included in the mortgage payment.

  2. FYI, most lenders want to control the payment of property taxes because they take priority over the mortgage. If the homeowner doesn’t pay them, the city can start power of sale regardless of the status of the mortgage payments. This can put the lender in peril of losses, especially when there is little equity in the home.

  3. Property taxes collected by the lender on behalf of the borrower are placed in escrow and are not subject to mortgage interest.

  4. “I agree that if a family assumes they’ll be able to put an extra $10,000 than option A is the better mortgage but how often does this type of scenario come up in the real world?”
    Hi Patrick,
    Thanks for the post. It is a minority of cases where this scenario applies. The real goal here was just to explain that exceptions to the lowest rate rule occur all the time. This particular story was meant just to illustrate one sample case. Ultimately, the interest rate is a deciding factor for most, but far from all, borrowers.
    P.S. Thanks to Robert and Joe for their replies on the tax issue.

  5. Another thing to consider: prepayment options can factor into the risk/cost balance when you have part of your mortgage at a fixed rate and part in a HELOC. You can then use the HELOC as the source for a large pre-payment against the fixed rate portion when rates are down: this increases your risk (exposure to a rise in interest rates) while decreasing your cost …

  6. If you run a deficit in your tax escrow account (i.e. the lender didn’t collect enough money with your monthly payments to cover the full tax bill from the city) then you could be subject to an interest charge – based on each lenders policy (although I can’t imagine any lender would pay the full amount and not charge you interest). To avoid this charge, you could simply make a lump sum payment to clear the tax escrow account deficit.
    If you run a surplus in the tax escrow account, I think most lenders will pay you interest.
    I know of at least one lender that charges interest equal to the rate on your mortgage, but only pays interest at a rate much lower (usually in line with a typical chequing account interest rate). At least that was their policy a few years ago.
    If you have further questions, ask your lender for details on their tax escrow policy.

  7. The problem for with prepayments for a lender is they allow the borrower to use their mortgage as a hedge against dramatic interest rate movement (up or down).
    If you have a locked in 5%, and rates skyrocket, then you don’t prepay. If you have a locked in 5% and rates drop then you do prepay.
    Check out the best 15, 20 & 25 year rates here http://www.canequity.com/.
    They went from 6.75 to 9.35% a couple of weeks ago. A 40% increase!

  8. 95% of people do not do pre-payments to the mortgage. In those instances they would be correct to go for the lowest rate. And by the way if you challenge an institution for example like Scotiabank who only allow 15% prepayment–if you want 25% they will allow you, it can be approved by the head office. Prepayments for most are nice ideas not reality.

  9. Youbet that statistic is not correct. The actual number is 33%.
    In addition, Scotia has never allowed 25% prepayments that I know of. They sometimes permit 20% but it is on an exception basis.
    On the other hand it is true that most people do not use their full 20% prepayments. For those who do it pays to consider this feature more seriously.

  10. 95%–33%?, please show me how you have stats on that? Point is majority of people cannot do, it sounds nice but does not happen.
    If you go through the right channels you can get 25% prepayment privileges–the office of the president can make a lot of things happen at every bank, they will not lose a deal because of this reason.

  11. Has anyone considered simply shortening the amortization to force the increase in payments – in effect matching what would have been paid if the full 20/20 options were exercised? This, coupled with the lower rate and fewer pre-payment options would seem like the most prudent choice if one wanted to save the most interest cost possible.

  12. I currently have a mortgage which is up for renewal in June. A conditional offer was accepted on a home that I want to purchase with a closing date on April 30th. I most likely will not stay with our current lender who is a credit union where the rate is higher. Can I still port my current mortgage to another lender at a lower rate or do I simply payout the existing and place a new first mortgage on the house I want to buy. Keeping in mind that there will be a penalty if I payout at the end of April as the mortgage isn’t up for renewal until June.

  13. You cannot port your mortgage to another lender–only with the same institution. To change to another lender prior to maturity will trigger a penalty.

  14. Given that there is only two months until maturity, perhaps you can ask the current credit union to waive the penalty? As a customer service gesture. Or, port the mortgage to the new property with the current CU, then switch at maturity to a new lender.
    Or, who knows …maybe the new lender will help absorb some/all of the penalty just to get your business?

  15. The original point I think was a bit of a useless one in my opinion. Prepaying is always good but how many people can afford to prepay the FULL amount EVERY year for the life time of the mortgage? I would guess less than 1% … there is some disagreement over the % of people who use pre-payment options but I can guarantee you that those people DO NOT prepay the full amount EVERY year for lifetime of the mortgage.

  16. Hi Sam,
    It is indeed small minority of borrowers who make full use of pre-payments. Our point was merely to say that there are many folks for whom other factors matter more than a low rate. This prepayment illustration was but one example.
    We have several clients, for example, who make full use of their pre-payments. It is a case-by-case issue.

  17. Maybe a person cannot utilize the full prepayment, but when they are leaving their lending institution and can utilize the full prepayment prior to a penalty being worked out it can make a big difference in the IRD. I believe the statistic is that most people pay out their mortgage after 3 years 4 months, so the larger the prepayment priveledge the less the penalty. I think that is where the difference between 10/15/20 and 25% make a difference.

  18. What about lenders that only let you make the prepayments on the anniversary date, or only once per year, vs being able to make multiple pre-payments any time, (keeping within the allowable limit per year).

  19. Strikes me that if a borrower has the ability to make 100% of prepayments, they should shorten their amortization, and get the lower interest rate. They can then add the 15% prepayment and come out ahead. I believe this post to be disingenuous; of course you will pay less interest if you increase your payments!
    If you put the same dollar figure into the 3.99% mortgage, you would save about $12,000 over the 4.49% mortgage. You would also only have about a seven year amortization.

  20. David,
    Setting one’s amortization to 7 years from the outset is not an option for many people because most don’t want to commit to a high monthly payment and might not qualify with one.
    Lump-sum pre-payments are just that. You only have to come up with the money once a year (applicable to people with bonus income, for example, or self-employed folks who require payment flexibility).
    P.S. Citizens Bank has a good pre-payment calculator where folks can run their own numbers. (Here is a screenshot of our calculations for convenience)

  21. Rob, you can set up your payments to be based on a 7 year amortization schedule,but still register the amortization for 25 years, etc, and the your are good to go.

  22. I think rob said it best:
    “Setting one’s amortization to 7 years from the outset is not an option for many people because most don’t want to commit to a high monthly payment”
    If you’re thinking about doing it after closing instead that won’t work either. Increasing a 25-year payment to a 7 year equivalent is not possible because it would greatly exceed the lenders allowable monthly payment increase.

  23. I think TD allows you to increase your scheduled payment (monthly, bi-weekly etc.) by 100% not just 20%). That would take a 25 year mortgage to at least 10 years.

  24. Incorrect, the key is your lender registering a longer amortization i.e. 25 years, but having your payments based on i.e. a 7 year amortization schedule, if it becomes to much say in a few years, or you want to lower your payments, the lender can increase your amortization without any re-registering or fees as they originally registered for the longer amortization.

  25. Seriously, I don’t know why you would want to shorten your amortization period. Quick math in my head, if you can and will handle 7 years amortization payment, you are better off having 35 years mortgage with 20% prepayment option and pay it off in 7 years. Why? Because ALL of your prepayment money goes directly to the principle, not interests. A 7 years amortization… How much interests would you be paying for the first 3 years? Please correct me if I am wrong.

  26. Olive it was already stated (and I fully agree with this) that most people don’t want the big monthly payments so a 7 year am. is not an option.
    As for TD, no offense but their rates are not that competitive. So who cares.
    Kyles point is interesting. For some reason it doesn’t seem intuitively correct but I tested his theory on the pre-payment calculator mentioned on this site and it seems true. Can anyone else confirm this?

  27. Hi,
    Would anybody know about this: can the penalty for breaking the mortgage on selling be calculated on the balance minus
    15% prepayment(without actually paying it)
    As I recall correctly this was an issue
    widely discussed.
    Comments are welcome

  28. Some lenders allow that if you stay with them. If they do cut you a break, they usually won’t have the best rates.
    If you leave a lender then you pay the whole penalty.

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