What Is Mortgage Prepayment Penalty In Canada?
Trying to get get your head around mortgage prepayment penalty? Explore this blog to find out everything you need to know.
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Are you having surplus cash and willing to prepay your mortgage? The decision might cost you extra dollars, as most mortgage lenders levy a penalty upon prepayment. Let us study this further.
What Is Mortgage Lending?
Most Canadians prefer to secure mortgage lending while purchasing a house. They provide the home as collateral or any other immovable asset of value. In return, the mortgage lender (usually financial institutions, such as banks) provides funds to the applicant.
The amount got via mortgage lending is nothing but a secured loan that you are required to pay back, along with the interest rate during the tenure of the loan.
If you have surplus cash or liquidity and wish to reduce your mortgage tenure or monthly installments, make balloon payments besides your regular monthly payments. We call it prepayment.
What Is Mortgage Prepayment and its Benefits?
All mortgage contracts contain a clause of prepayment, which will allow you to prepay your outstanding debt. It refers to the additional amount you will pay on top of your regular payments. It helps you to achieve:
1. Reduction of Loan Tenure
By prepaying, you reduce the total outstanding mortgage loan. If you wish to maintain the regular payments, you will repay this reduced loan in less time, reducing your overall loan tenure.
For example,
Alex got a mortgage loan of $100,000 from ABC Bank of Canada for 5 years (60 installments) @5.25%. It translates into a monthly mortgage payment of $1,899. After paying installments for 3 years, Alex prepaid $30,000.
The opening balance of the mortgage loan at the beginning of the fourth year was $43,166. The prepayment of $30,000 reduced the overall outstanding loan to $13,166 ($43,166−$30,000).
Alex kept paying the original mortgage payment of $1899 and reduced the overall loan tenure from 5 years to 3 years and 7 months.
2. Reduction of Regular Mortgage Payments
The other option is to keep your loan tenure intact. Instead, reduce your monthly mortgage payments.
In continuation of the above example,
Alex, at the time of prepayment, reduced his monthly mortgage payments. He kept his loan tenure like before. It reduced his burden of monthly mortgage repayments from $1,899 to $579.
How is Mortgage Prepayment Penalty Charged in Canada?
Prepayment of debt helps you gain mental peace and financial freedom. But this certainly comes at a cost, the Mortgage prepayment penalty.
Mortgage prepayment penalty
It is a variable penalty that varies from lender to lender. A lender would calculate following the rules and regulations of the various mortgages.
Your mortgage prepayment penalty will always depend on:
- The tenure left
- The amount you wish to prepay
- The prevailing interest rate (with a floating mortgage)
- The method of calculation followed by your lender
Mostly, the prepayment penalty will be higher:
- The interest amount of three months calculated on your current outstanding balance of the mortgage loan
- The Interest Rate Differential (IRD)
Most mortgage lenders have put a mortgage penalty calculator on their website that you can use to know the penalty amount.
How to Avoid Mortgage Prepayment Penalty?
Several regulated lenders (such as established banks) offer a prepayment privilege to their customers. It refers to an additional amount you can pay towards your mortgage loan over and above your regular mortgage payments.
If your prepayment amount remains within the limits of this prepayment privilege, then you will not be required to pay any prepayment penalty.
Again, the amount of prepayment privilege differs from lender to lender. The lender would usually mention it in the mortgage contract.
What Are the Benefits of Prepayment Privilege?
A prepayment privilege is usually a percentage of the original mortgage loan that helps you to:
- Augment your regular mortgage payments by a specific percentage
- Reduce your overall outstanding mortgage loan every year with a definite amount
- It stops you from paying any prepayment penalty
Typically, the amount of prepayment privilege is for a particular year and cannot be carried forward to another year.
If you could not exhaust your quota of prepayment privilege this year, you cannot carry forward this balance amount to the subsequent years. It happens because such a balance will lapse at the end of the current year.
Why do Banks Levy a Prepayment Penalty?
It is a fact that financial institutions and other lenders are always in need of funds to disburse them as loans and advances. By making a prepayment, you are funding your lender with some funds. Then, why does it charge a penalty from you?
The answer lies because, by making prepayments, you have disturbed the overall cash flow of your lender.
It will take time for your lender to use the unexpected cash flow received from you. It will lead to a loss of interest.
Interest income is the primary source of income for lending institutions, and by making prepayment penalty charges, you are simply compensating your lender for this interest loss.
Further, since you have made some prepayments, you are not required to pay any interest on this prepaid amount that adds to the lender’s income losses of interests.
